What is a Debenture?

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Definition:

A debenture is a type of bond that isn’t backed by any sort of collateral — The lender trusts the borrower to pay it back.

🤔 Understanding debentures

A debenture is a type of bond that a government or corporation can use to raise capital. As with other bonds, those who invest in debentures loan the entity money and get it back with interest. A debenture is a type of unsecured debt. There is no collateral behind it, meaning there is no asset for the lender to seize if the borrower defaults on the loan. Instead, investors trust that the organization they are lending money to will pay them back. Since the entities issuing debentures are often governments or large corporations, investors assume the borrower is good for the money. Debentures can be a good option for companies with strong credit ratings, because they can borrow money without putting their assets on the line.

Example

Imagine that the fictional Rivertown is preparing to build a new town hall. The local government decides to raise money for the project through bonds — specifically, debentures. Because a debenture is an unsecured debt, the town doesn’t have to worry about putting up any collateral. Eventually, the government will pay back each of the investors with interest.

Takeaway

A debenture is like a credit card…

Credit card companies loan borrowers money, even though they don’t put up collateral. If a borrower has a good credit score, the company bets he or she will repay the debt. Similarly, investors lend money to companies and governments through debentures, trusting they’ll get the funds back.

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How does a debenture work?

Corporations and governments usually use debentures (unsecured bonds) to borrow for the medium or long term. Debentures come with either fixed or floating (variable) interest rates and pay interest payments, known as coupons, on a regular schedule. Debentures have predetermined maturity dates — This is when the issuing entity will pay back investors in full.

As with other types of bonds, debentures tend to be lower risk than many other types of debt investing, even taking into account the fact that they don’t have collateral backing them up. US Treasury bonds are well-known examples of debentures.

What are the types of debentures?

There are two types of debentures: convertible and nonconvertible.

Convertible debenture

A convertible debenture, issued by corporations, can convert into company shares after the bond reaches maturity based on a set ratio. These debentures can be advantageous to people investing in bonds issued by companies they believe will continue to grow. But they tend to pay a lower interest rate than their nonconvertible counterparts.

Convertible debentures can take a few different forms. Some give investors the option to convert the bond to stock in the company, while others force the conversion. Finally, some debentures are partially convertible, meaning some of the investment converts into shares while the rest follows the ordinary course of a bond investment.

Nonconvertible debenture

Nonconvertible debentures are those that can’t convert into stock. Because they don’t have this extra perk, they often come with a higher interest rate. Companies are willing to pay a higher rate because these bonds don’t dilute the company’s stock by turning into shares.

What are the features of a debenture?

All debentures share some common features:

Credit rating

Debentures don’t have any collateral backing them up, so the credit rating of the company or government issuing them is especially important. A credit rating will appear as a letter grade on a scale of AAA to D (with AAA being the best and D being the worst). The credit rating is an indication to investors about how risky a given debenture is.

Interest rate

Most bonds come with a stated interest rate (the periodic payments made to investors, also called coupon payments). A debenture’s interest rate can be fixed, meaning it doesn’t change over the life of the bond. Or it can be floating, meaning it adjusts over time based on market interest rates.

The interest rate is what determines the amount of your coupon payments. For example, if you invest $1,000 in debentures with a 5 percent interest rate, your annual interest payment will be $50.

Maturity

The maturity date is when the debenture expires and when the issuing entity must pay back its investors. It can make the payments in a lump sum at the maturity date or in periodic payments until then. Convertible debentures can instead convert into stock at the maturity date.

What is a debenture vs. a bond vs. a loan?

A bond is a debt instrument that governments and corporations use to raise money. A bond is similar to a loan in that the entity borrows money and pays periodic interest (coupon) payments. By the time the bond reaches maturity, investors are promised to get all their money back with interest.

All debentures are bonds, but not all bonds are debentures. There are secured and unsecured bonds. A secured bond is backed by collateral, such as a property or equipment. If the borrower defaults, you can seize the asset instead. An unsecured bond, like a debenture, doesn’t have any collateral backing it up. Investors rely only on the trustworthiness and credit rating of the company or government issuing the bond.

A debenture is different from a bank loan. With a bank loan, an entity borrows money from a financial institution, while with a debenture, a government or business borrows money from members of the public. Bank loans usually require the borrower to put up some collateral, whereas debentures don’t. Debentures can be sold to other parties, while bank loans usually can’t be transferred.

What is the difference between a debenture and a stock?

Investing in a debenture, or any kind of bond that a corporation has issued, is not the same as buying stock in the company. One critical difference is that investing in a debenture gives you no ownership or voting rights in the company — You’ve simply loaned the company money.

With a debenture, especially a fixed-rate one, your return doesn’t change depending on the company’s profits. So if the company takes off and its earnings skyrocket, you don’t get any more money back. Shareholders, on the other hand, are likely to benefit thanks to a higher stock price or dividends.

At first blush, it might seem like investing in debentures is a worse deal. After all, you don’t get to enjoy any of the perks of the company’s growth potential. But these bonds generally come with a lot less risk than buying stock in a company. While your interest payments don’t change based on the company’s profits, they generally don’t change based on the company’s losses as long as you don't sell your debentures. If the company’s stock performs poorly, shareholders can lose money while debenture holders will likely continue to receive their interest payments so long as the company's poor performance does not get worse. And if the company goes under, debentures usually have precendence over shareholders when it comes to being made whole. This does not guarantee you will be made whole, but gives you an edge in these events.

Debentures also have the potential to provide more flexibility than stocks. There’s no option for converting your equity in a company into a debenture. But if you invest in a convertible debenture, you could someday convert that into company shares.

What are the advantages and disadvantages of a debenture?

Advantages

As with other bonds, most debentures pay regular interest rate returns (the coupon payment). This feature can be attractive on long-term debt instruments, since investors don’t have to wait until the maturity date or selling the asset to see a return.

Some debentures are also convertible, meaning they can turn into stock in the corporation issuing the bonds. This can result in even more profit to an investor in the long run.

Overall, debentures, as with other bonds, tend to be lower-risk investments. Debentures are a standard debt instrument tool. Even though they are unsecured, investors can usually be confident that they’ll get their money back. US Treasury bonds, for example, are debentures that are considered virtually risk-free, as the US government backs them.

Disadvantages

Debentures are not totally without risks. For one, there’s no guarantee the interest rate will keep up with inflation (a general increase in prices). If inflation outpaces the interest rate on a debenture, then you’ve lost money. For an investment where the interest rate is often just a few percent, this is not an unrealistic scenario. The stock market, on the other hand, has historically provided higher average returns in the long run, meaning the chances of losing money to inflation are slimmer.

With a debenture, you also run the risk of the bond decreasing in value compared to other investment options. For example, the market interest rate may increase while your money is tied up in a debenture with a fixed interest rate (one that doesn’t change over the life of the investment). You’re stuck with the opportunity cost of not making as much money as you potentially could have.

Finally, debentures do include some risk of default. A debenture is an unsecured investment, meaning it doesn’t have the backing of any collateral. If the issuing company defaults, then you’re out your money. For this reason, investors must consider the creditworthiness of a corporation before investing in a debenture. You probably don’t have to worry about this with US Treasury bonds, since the federal government backs those.

The good news is that if a corporation files for bankruptcy, it pays debentures before paying back shareholders. But it doesn’t pay debentures until after paying off any secured debt, including secured bonds.

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