What Are Debentures?

A debenture is a medium or long term debt format that large companies use to borrow money at a fixed rate of interest. It is unsecured by collateral and thus it relies on the credit worthiness and reputation of the issuer for support. Both corporations and governments frequently issue debentures to raise capital or funds. It is normally a loan that should be repaid on a specific date, but some debentures are irredeemable securities.

Introduction

Similar to most bonds, debentures may pay periodic interest payments called coupon payments. Like other types of bonds, debentures are documented in an indenture. An indenture is a legal and binding contract between bond issuers and bondholders. The contract specifies features of a debt offering, such as the maturity date, the timing of interest or coupon payments, the method of interest calculation, and other features. Corporations and governments can issue debentures. Although the money raised by the debentures becomes a part of the company’s capital structure, it does not become share capital. These debt instruments pay an interest rate and are redeemable or repayable on a fixed date. A company typically makes these scheduled debt interest payments before they pay stock dividends to shareholders. Debentures are advantageous for companies since they carry lower interest rates and longer repayment dates as compared to other types of loans and debt instruments.

Governments typically issue long-term bonds—those with maturities of longer than 10 years. Considered low-risk investments, these government bonds have the backing of the government issuer.

Types of Debentures

Convertible debentures: Convertible bonds or bonds that can be converted into equity shares of the issuing company after a predetermined period of time. Convertible debentures are hybrid financial products with the benefits of both debt and equity. To investors, convertible bonds are more attractive because the bonds can be converted, and to companies they have the advantage that they normally have lower interest rates than non-convertible corporate bonds.

Non-convertible debentures: Standard debentures that can’t be converted into equity shares of the liable company. Since they can’t be converted, they usually have higher interest rates than convertible debentures.

Features

Fig: Debentures

When issuing a debenture, first a trust indenture must be drafted. The first trust is an agreement between the issuing corporation and the trustee that manages the interest of the investors.

Interest Rate : 

The coupon rate is determined, which is the rate of interest that the company will pay the debenture holder or investor. This coupon rate can be either fixed or floating. A floating rate might be tied to a benchmark such as the yield of the 10-year Treasury bond and will change as the benchmark changes.

Credit Rating:  

The company’s credit rating and ultimately the debenture’s credit rating impacts the interest rate that investors will receive. Credit-rating agencies measure the creditworthiness of corporate and government issue.   These entities provide investors with an overview of the risks involved in investing in debt.

Credit rating agencies, such as Standard and Poor’s, typically assign letter grades indicating the underlying creditworthiness. The Standard & Poor’s system uses a scale that ranges from AAA for excellent rating to the lowest rating of C and D. Any debt instrument receiving a rating of lower than a BB is said to be of speculative-grade. You may also hear these called junk bonds. It boils down to the underlying issuer being more likely to default on the debt.

Maturity Date

For nonconvertible debentures, mentioned above, the date of maturity is also an important feature. This date dictates when the company must pay back the debenture holders. The company has options on the form the repayment will take. Most often, it is as redemption from the capital, where the issuer pays a lump sum amount on the maturity of the debt. Alternatively, the payment may use redemption reserve, where the company pays specific amounts each year until full repayment at the date of maturity.

Advantages

  • One of the biggest advantages of debentures is that the company can get its required funds without diluting equity. Since debentures are a form of debt, the equity of the company remains unchanged.
  • Interest to be paid on debentures is a charge against profit for the company. But this also means it is a tax-deductible expense and is useful while tax planning
  • Debentures encourage long-term planning and funding. And compared to other forms of lending debentures tend to be cheaper.
  • Debenture holders bear very little risk since the loan is secured and the interest is payable even in the case of a loss to the company
  • At times of inflation, debentures are the preferred instrument to raise funds since they have a fixed rate of interest
Fig: Advantages of Debentures

Disadvantages

  • The interest payable to debenture holders is a financial burden for the company. It is payable even in the event of a loss
  • While issuing debentures help a company trade on equity, it also makes it to dependent on debt. A skewed Debt-Equity Ratio is not good for the financial health of a company
  • Redemption of debentures is a significant cash outflow for the company which can imbalance its liquidity
  • During a depression, when profits are declining, debentures can prove to be costly due to their fixed interest rate

Conclusion

An example of a government debenture would be the U.S. Treasury bond (T-bond). T-bonds help finance projects and fund day-to-day governmental operations. The U.S. Treasury Department issues these bonds during auctions held throughout the year. Some Treasury bonds trade in the secondary market. In the secondary market through a financial institution or broker, investors can buy and sell previously issued bonds. T-bonds are nearly risk-free since they’re backed by the full faith and credit of the U.S. government. However, they also face the risk of inflation and interest rates increase.

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