A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond to secure capital. Like other types of bonds, debentures are documented in an indenture.
BREAKING DOWN ‘Debenture’
Debentures have no collateral. Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default on the repayment. An example of a government debenture would be any government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills are generally considered risk free because governments, at worst, can print off more money or raise taxes to pay these types of debts.
Debentures are the most common form of long-term loans that can be taken out by a corporation. These loans are normally repayable on a fixed date and pay a fixed rate of interest. A company normally makes these interest payments prior to paying out dividends to its shareholders, similar to most debt instruments. In relation to other types of loans and debt instruments, debentures are advantageous in that they carry a lower interest rate and have a repayment date that is far in the future.
Convertible and Non-Convertible Debentures
There are two types of debentures as of 2016: convertible and non-convertible. Convertible debentures are bonds that can convert into equity shares of the issuing corporation after a specific period of time. These types of bonds are the most attractive to investors because of the ability to convert, and they are most attractive to companies because of the low interest rate.
Non-convertible debentures are regular debentures that cannot be converted into equity of the issuing corporation. To compensate, investors are rewarded with a higher interest rate when compared to convertible debentures.
Features of a Debenture
All debentures have specific features. First, a trust indenture is drafted, which is an agreement between the issuing corporation and the trust that manages the interest of the investors. Next, the coupon rate is decided, which is the rate of interest that the company will pay the debenture holder or investor. This rate can be either fixed or floating and depends on the company’s credit rating or the bond’s credit rating.
For non-convertible debentures, the date of maturity is also an important feature. This date dictates when the issuing company must pay back the debenture holders. However, the company has a few options for how it will repay. The most common form of repayment is called a redemption out of capital, in which the issuing company makes a lump sum payment on the date of maturity. A second option is called a debenture redemption reserve, in which the issuing company transfers a specific amount of funds each year until the debenture is repaid on the date of maturity.