What is a Debenture?
A debenture is a type of debt instrument that is not backed by any collateral. This means debentures rely solely on the creditworthiness and reputation of the issuer. Both corporations and governments frequently issue debentures to raise capital for various purposes.
Key Takeaways
- A debenture is an unsecured debt instrument, typically with a term greater than 10 years.
- Debentures depend on the creditworthiness and reputation of the issuer for backing.
- Both corporations and governments often issue debentures to raise funds.
- Some debentures can convert to equity shares while others cannot.
Understanding Debentures
Similar to most bonds, debentures may pay periodic interest payments called coupon payments. The details and terms of a debenture are usually specified in a legal document called an indenture. Both corporations and governments can issue debentures for long-term loans.
Governments typically issue longer-term debentures, often considered low-risk due to the backing of the government. On the other hand, corporate debentures rely on the financial strength and creditworthiness of the company, usually offering lower interest rates and longer repayment periods compared to other loans.
Types of Debentures
Registered vs. Bearer
Debentures can either be registered to the issuer or issued as bearer debentures. Registered debentures require organized transfers through a clearing facility, while bearer debentures automatically entitle the holder to interest upon possession.
Redeemable vs. Irredeemable
Redeemable debentures specify the date and terms by which the debt must be repaid in full. Conversely, irredeemable debentures, also known as perpetual debentures, do not have a set repayment date.
Convertible vs. Nonconvertible
Convertible debentures can convert into equity shares of the issuing corporation after a predetermined period, combining the advantages of both debt and equity. Nonconvertible debentures cannot be converted into equity and usually offer a higher interest rate as compensation.
Features of a Debenture
Interest Rate
The coupon rate is the interest rate the company will pay to the debenture holder, which can be fixed or floating.
Credit Rating
The credit rating impacts the interest rate and overall attractiveness of the debenture. Credit-rating agencies provide investors with insights into the creditworthiness of both corporate and governmental debentures.
Maturity Date
For nonconvertible debentures, the maturity date is crucial, dictating when the company must repay the debt. Repayment might be in a lump sum or installments through a redemption reserve.
Pros and Cons of Debentures
Pros
- A regular interest return is provided to investors.
- Convertible debentures can be converted to equity, making them appealing.
- Debentures have priority over common stock in bankruptcy scenarios.
Cons
- Fixed-rate debentures are exposed to interest rate risks.
- The creditworthiness of the issuer is critical to avoid default risk.
- There’s an inflationary risk if the coupon does not keep up with inflation.
Debenture Risks to Investors
Investors face various risks, including inflationary risk, interest rate risk, and default risk. The performance of a debenture heavily relies on the issuer’s financial health and market conditions.
Example of a Debenture
One example is the U.S. Treasury bond (T-bond). These bonds finance government operations and are sold during auctions held yearly. While they are nearly risk-free, they do face inflation and interest rate rise risks.
How Is a Debenture Different From a Bond?
Debentures are a subset of bonds and are unsecured or non-collateralized. Secured bonds, in contrast, are backed by collateral like property or other assets, making them safer but often offering lower interest rates.
Are Debentures Risky Investments?
Debentures tend to be less risky than equity investments but more risky than secured debts. Despite this, they often offer higher interest rates to compensate for this added risk.
How Are Debentures Structured?
Debentures involve a standard structuring process, including drafting a trust indenture and deciding on a coupon rate. The credit rating also influences the interest rate, and debentures can be convertible or non-convertible.
Is a Debenture an Asset or a Liability?
A debenture is an asset for the investor but a liability for the issuer, who is borrowing money through these securities.
The Bottom Line
Debentures are a versatile form of unsecured bond issued by both corporations and governments. While riskier than secured bonds, they offer the potential for higher returns and form a significant method of raising capital.
Related Terms: Bond, Debt Instrument, Loan, Creditworthiness.
References
- Investor.gov. “Debentures”.
- U.S. Securities and Exchange Commission. “What Are Corporate Bonds?” Page 2-3.
- S&P Global. “S&P Global Ratings Definitions”.
- U.S. Securities and Exchange Commission. “What Are Corporate Bonds?” Page 4.
- U.S. Securities and Exchange Commission. “What Are Corporate Bonds?” Page 1.
- TreasuryDirect. “Treasury Bonds”.
