Debenture types, examples, features and risk
Debentures are types of bonds with some risks and advantageous features used by corporations and governments to raise funds. A typical debenture example is the treasury bonds and treasury bills. This type of bond is usually crucial for raising long-term debt capital.
Technically, a debenture represents a document that either creates a debt or acknowledges it. It is, therefore, the acknowledgment of the debt the organization has taken from the public at large. In some countries, debenture bonds are the same as a bond, note, or loan stock, and are used interchangeably with them.
Let’s look at a more detailed explanation of debenture.
What is a debenture?
This simply means a debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money from the public and has promised to pay it back at a future date. The creditors of the company are referred to as debenture holders, and debentures are freely transferable by these creditors.
In economics, a debenture can be defined as a medium- to long-term debt instrument used by large companies and organizations to borrow money, at a fixed rate of interest. It is more like a loan bond or certificate of loan showing the company’s liability to pay a specified amount with interest.
Furthermore, debentures in accounting are a form of debt capital. Hence, it is accounted for as debt on the balance sheet of the issuing company. The money raised by the debentures becomes part of the company’s capital structure but does not become share capital. This is why senior debentures are paid before subordinated debentures.
How do debentures work?
A debenture bond is a type of unsecured bond or debt instrument that is unsecured by collateral. Therefore, the issuance of a debenture is a legal certificate that shows the principal (money given by the investor), the interest rate to be paid, and the schedule of payments.
Hence, it is when the debenture matures (i.e at the end of the term) that investors receive their principal back. The interest on debenture is a charge opposite to the profit of the enterprise. This means on debentures, the interest has to be paid whether the enterprise has acquired any profit. Debentures, like the majority of other bonds, may pay periodic interest payments known as coupon payments.
Debentures pay an interest rate and are redeemable or repayable on a fixed date. Usually, an organization or company makes these scheduled debt interest payments before they pay stock dividends to shareholders. There are several advantages and disadvantages of debentures. A typical advantage of debentures for companies, as compared to other types of loans and debt instruments is that they carry lower interest rates and longer repayment dates.
Debentures can be issued by corporations and the government. Governments, in most cases, issue long-term bonds; with maturities longer than 10 years. These government bonds tend to have the backing of the government issuer and are considered low-risk investments. Corporations, on the other hand, also use debentures as long-term loans. However, the debentures of corporations are unsecured and rather have the backing of only the creditworthiness and financial viability of the underlying company.
Similar to other types of bonds, debentures are documented in an indenture. This indenture is a legal contract that binds bond issuers and bondholders. The contract specifies attributes of a debt offering, such as the timing of interest or coupon payments, maturity date, method of interest calculation, and other attributes.
Debenture examples
The U.S treasury bond (T-bond) is a typical example of a government debenture. Treasury bonds help to finance projects and fund the daily governmental operations. During auctions held throughout the year, the US treasury department issues debentures.
These treasury bonds, as a debenture example, are nearly risk-free because they are backed by the full credibility of the U.S government. Nevertheless, these T-bonds also face the risk of interest rates increase and inflation. Furthermore, some T-bonds trade in the secondary market. Investors can buy and sell previously issued bonds in the secondary market, through a financial institution or broker.
Types of debentures
- Convertible debenture
- Non convertible debenture
There are basically two main types of debentures:
Convertible debenture
Large corporations issue some debentures that can be converted into ownership shares in the company that issued them. This is one of the debentures types referred to as convertible debenture. The definition of a convertible debenture is simply said to be bonds that can be converted into equity shares of the issuing company after a specific period. Corporations may add the ‘convertibility’ features to the bonds they issue in order to make them more attractive to buyers. This type of bond is of advantage to a buyer because of its ability to convert.
They are hybrid financial products with the benefits of both debt and equity. Thus, companies make use of debentures as fixed-rate loans and pay fixed interest payments. Nevertheless, the debenture holders have the option of converting the loan into equity shares or holding the loan until maturity and receiving the interest payments. Therefore, the convertible debenture is attractive to investors that want to convert to equity if they believe that in the long term, the company’s stock will rise. Moreso, it has lower interest rates than non-convertible corporate bonds. However, since convertible debenture pays a lower interest rate compared to other fixed-rate investments, the ability to convert to equity comes at a price.
Furthermore, a convertible debenture example is the CCD which means Compulsory convertible debenture. The CCD is one form of convertible debenture, a bond that must be converted into stock by a specified date. This type of bond is classified as hybrid security because it is not purely a stock or purely a bond. However, the difference with CCD as compared to convertible debentures is that its owner must accept stock in the company when it matures instead of having the option of receiving stock or cash.
Non convertible debenture
These types of debentures cannot be converted into equity shares of the liable company. Hence, they are debentures with no convertibility feature attached to them and usually carry higher interest rates compared to their convertible counterparts. Non-convertible debentures are, therefore, regular or traditional debentures that cannot be converted into equity shares of the issuing corporation/ liable company. It is because of their inability to convert, that they carry higher rates than convertible debentures.
What is a subordinated debenture?
This simply means that the holders of more senior securities are first paid before any residual funds are made available to the holder of the subordinated debenture. Given the higher risk of nonpayment, this security pays out a relatively high-interest rate, either because investors are buying it at a discount or it has a high coupon rate.
Usually, when a company is forced to file for bankruptcy and must have its asset liquidated to pay investors, bondholders are normally first in line to get their money back. The stockholders then receive whatever money is left, if any. However, even as bond owners are the first to be repaid if a company defaults, not all bonds are created equal. Some have a higher priority than others and in such cases, subordinate debenture bonds hold the absolute lowest rank in the bond industry.
Features of debentures
- Interest rate
- Debenture holders
- Credit rating
- Maturity date
Debenture bonds are followed by a standard structuring process and have the common features listed above. A debenture bond is a type of unsecured bond, thus when issued, a trust indenture must be drafted first. Usually, the first trust is an agreement between the debenture trustee that manages the interest of the investors and the issuing corporation. The coupon rate is decided next, which is the interest rate that the company has to pay the investor/debenture holder. This interest rate depends on the company’s credit rating or the bond’s credit rating and can also be either fixed or floating. Moreso, debentures can be convertible or nonconvertible into common stocks.
Interest rate
The interest rate (debenture rates) that the company will pay the debenture holder or investor which is known as the coupon rate is usually determined. It can be fixed or floating. A floating rate might be tied to a benchmark e.g the yield of the 10-year Treasury bond and will definitely change as the benchmark changes.
Debenture holders
During the issuance of debentures, the creditors of the company are referred to as debenture holders. A debenture holder (also known as the investor) has no right to vote in the company’s general meetings of shareholders but may have separate meetings or votes e.g. on changes to the rights attached to the debentures. The interest paid to debenture holders is usually calculated as a charge against profit in the company’s financial statements.
Credit rating
The interest rate that investors will receive is impacted by the company’s credit rating and the debentures’ credit rating. The creditworthiness of corporate and government issues is measured by credit-rating agencies. These agencies give investors an overview of the risks involved in investing in debt.
An example of such credit-rating agencies is the Standard and Poors (S&P). This agency assign letter grades indicating the underlying creditworthiness. The S&P’s system uses a scale that ranges from AAA for excellent rating to the lowest rating of C and D. Therefore, any debt instrument that receives a rating lower than BB is said to be of speculative grade. One can also hear these called junk bonds which boil down to the underlying issuer being more likely to default on the debt.
Maturity date
The maturity date indicates when the company must pay back the debenture holders and the company usually has options on the form the repayment will take. Most times, it is as redemption from the capital, where the issuer pays a lump sum amount on the maturity of the debt. The payment, alternatively, may use a redemption reserve where the company pays specific amounts each year until the full repayment at the maturity date. The date of maturity is a crucial feature for nonconvertible debentures.
Risks associated with debentures
- Inflationary risk
- Interest rate risk
- Credit and default risk
Inflationary risk
Investors may face inflationary risk. If the coupon paid does not keep up with the rate of inflation, debentures may have inflationary risk. Inflation measures economy-based price increases. Say inflation, for instance, causes prices to increase by 3%, and should the debenture coupon pay at 2%, the holders may see a net loss in real terms.
Interest rate risk
Debenture holders may face interest rate risk. In an environment where the market interest rate is rising, fixed-rate debentures may have interest rate risk exposure. In such situations, investors hold fixed-rate debts during times of rising market interest rates. They may find their debt returning less than what is available from other investments paying the current, higher, market rate. The debenture holder ends up earning a lower yield in comparison if this happens.
Credit and default risk
A debenture may carry credit and default risk. Debentures are only as secure as the underlying issuer’s financial strength. Hence, when considering the chance of default risk from the underlying issuer’s financial viability, creditworthiness is very crucial. This means, that once a company struggles financially as a result of macroeconomic and internal factors, investors are at risk of default on the debenture. So, as consolation, in the event of bankruptcy, an investor would be repaid before common stock shareholders.
Advantages of debentures
- Companies do not involve their profits in debentures.
- A major advantage of debentures is that the debenture is paid before common stock shareholders in the event of a corporation’s bankruptcy.
- Debentures pay a coupon rate or regular interest rate to investors.
- Investors who want fixed income at lesser risk would prefer debentures.
- After a specific period, convertible debentures can be converted to equity shares which makes them more appealing to investors.
- Since debentures do not carry voting rights, financing through them doesn’t dilute control of equity shareholders on management.
- As the interest payment on debentures is tax-deductible, financing through debentures is less costly as compared to the cost of preference or equity capital.
- It is appropriate for the issue of debentures when the sales and earnings are relatively stable.
Disadvantages
- Each company has a certain borrowing capacity. Hence, the capacity of a company to further borrow funds reduces with the issue of debentures.
- Even during periods of financial strain on the company, when it comes to redeemable debenture, the company has to make provisions for repayment on the specified date.
- A major disadvantage of debenture is that it puts a permanent burden on the earnings of a company. Thus, there is a greater risk when the earnings of the company fluctuate.
Debenture vs bond
Bonds may be similar but debentures are unsecured, unlike bonds. The difference between bond and debenture is that if defaults occur, debenture holders have no claim to the assets. As opposed to other bonds, debentures are usually issued by large corporations with triple-A credit ratings because repayment is based mainly on the creditworthiness of the issuing organization.
The table below highlights the comparison between bond vs debenture, based on several criteria.
| CRITERIA FOR COMPARISON | DEBENTURES | BONDS |
| Definition | Debentures are a type of bond issued by a business, company, or organization to raise capital or funds for long-term activities and growth which has no collateral backing and, for support, only relies on the reputation and creditworthiness of the issuer. | Bonds are debt financial instruments issued by government agencies, financial institutions, and large corporations that are usually backed up by physical assets or collaterals. |
| Owner | The owner of a debenture is referred to as the debenture holder | The owner of a bond is referred to as a bondholder. |
| Collateral or no collateral | Debentures get secured without collateral or physical assets of the issuing company. Lenders get these instruments based mainly on the reputation of the issuing company. | Bonds are usually secured by the physical assets or collateral of the issuing company. |
| Tenure | Generally, debentures are short to medium-term investments and have tenures lower than bonds. | Bonds are generally long-term investments with higher tenures than debentures. |
| Issuer | Private companies, for their immediate capital requirements, generally issue debentures | For long-term capital requirements, financial institutions, government agencies, and large corporations issue these bonds. |
| Interest rate | The interest rate of debentures is fixed or floating and is generally higher than bonds. This is because they are not backed by collateral and are less stable in terms of repayment. | The interest rate of bonds is fixed or floating and is generally lower than debentures. This is because they get backed by collateral of the issuing company and are more stable in terms of repayment. |
| Priority during liquidation | If the company is on the verge of liquidation, the debenture holders are given second priority over bondholders. For the repayment of capital and interest amount, they are given second priority over bondholders. | For the repayment of capital and interest amount, the bondholders are given priority over debenture holders if the company is on the verge of liquidation. |
| Payment Structure | The payment structure of interest for this type of bond depends on the company’s performance and is done on a periodical basis. | The payment structure of interest for bonds is not dependent on the performance of a company and is done on an accrual basis. The issuing company pays this interest on a monthly, half-yearly, or yearly basis. |
| Risk | Since debentures do not have the security of the physical assets of the issuing company, they are riskier than bonds | Since bonds have the security of the physical assets of the issuing company, they are less risky than debentures. |
Debenture vs indenture
A debenture is usually issued under an indenture. The debenture is a certificate that evidences an amount of money owed to someone, more like a certificate of indebtedness whereas, an indenture is a legal contract that is made between the bond issuer and the bondholder.
Once a debenture is issued, a trust indenture must be drafted first. This indenture, which is also known as the “Deed of Trust” is a mutual written agreement between the two parties where the bond issuer is required to state all the terms and conditions of the contract.
The bond issuer expresses all facts of the contract which would include the rate of interest, amount of interest paid, date of redemption, price or ratio (if the bond is convertible), and other terms. The modern usage of indenture is generally for real estate transactions and commercial debts.
