Debenture

A debenture is a type of debt instrument without collateral. Debentures rely on the creditworthiness and issuer reputation due to the absence of collateral. Governments and large companies often issue debentures (e.g., bonds) to attract financing from investors.

Understanding Debentures

Debentures are similar to bonds. They can earn periodic interest payments (coupons) and are similarly issued through a contract of legal obligations between the issuers and bondholders. Such a contract is called an indenture. It describes the characteristics of the debt offering (maturity date, timing and method of interest or coupon payment, etc.).

Usually, government bonds are less risky because of the issuing government backing. Such bonds are usually long-term. They can have maturities of 10 years and longer.

Unlike the company's bonds, the company's debentures are not secured by collateral, but can be used as long-term loans.

Instead of collateral, debentures are guaranteed by the creditworthiness and viability of the company-owner. Same as bonds, debentures earn interest and can be repurchased or matured on a fixed date. As a rule, a company pays interest on debentures first, and then pays dividends to shareholders. Interest rates on debentures are lower and repayment dates are longer than for other types of credits. Therefore, it is more profitable for companies to issue debentures than other types of debt instruments.

Convertible vs. Nonconvertible

Convertible debentures are bonds of the issuing company that can be converted into shares after a certain period. Convertible debentures are a hybrid financial instrument with the advantages of debt and equity. Company debt often plays the role of fixed-rate loans with fixed interest payments. At the same time, debt holders have an opportunity to hold a loan until maturity and get interest payments.

Investors who are confident in the long-term growth of the company's stock are interested in convertible debentures. Of course, they carry a certain expense since their interest rate is slightly lower than other fixed-rate investments, but this is compensated by the convertibility.

Nonconvertible debentures are classic debentures of the issuing company without the possibility of conversion into the shares. Their interest rate is higher than convertible debentures, but it is not possible to convert them into shares.

Features of a Debenture

Before debentures can be issued, an agreement between the issuing company and the trustee of the investors' interests (the trust indenture) has to be formed.

Interest rate. The agreement specifies that the company will pay a coupon rate (a fixed or floating interest rate) to the debt holder or investor. The floating rate depends on changes in the benchmark. For example, the benchmark could be the yield of a 10-year Treasury bond.

Credit rating. This is the creditworthiness of the company and government issues. The credit rating of a company, and therefore its bonds, affects the interest rate paid to investors. Special agencies calculate a credit rating based on the risks of investing in debt and assign a certain letter. There is a scale from AAA (excellent rating) to C and D (the worst ratings). A rating lower than BB treats a debt instrument as an undesirable (speculative) one. The probability of such issuers to default on the debt is high.

Maturity date. It determines the date of debt repayment to debenture holders. The company can repay debts in several ways. One is through a capital redemption, which means that the issuer pays a total amount in a one-time payment on the debt's maturity date. The other way is a redemption reserve, which means that the company pays the amount in certain parts until the full amount of payment on the maturity date.

Debenture risks to investors

One of the risks is that the rate of inflation can significantly exceed the interest rate paid on the debt debentures.

Another risk could be the holdings of fixed-rate debt at a time of market interest rate rises.

Also, a default on debt obligations can be a risk, if the company has financial difficulties, caused by internal or macroeconomic factors.