Debenture

A debenture is a type of debt instrument that is not secured by collateral. Debentures are backed only by the creditworthiness and reputation of the issuer. Both corporations and governments frequently issue debentures to raise capital or funds.

Debentures can be issued by governments and corporations. Governments typically issue long-term bonds or bonds with maturities of longer than ten years. On the other hand, corporations use debentures as long-term loans. Debentures can pay periodic interest payments called coupon payments. Government bonds are considered low-risk investments since they're backed by the government. However, debentures of corporations are unsecured and are backed by the financial viability and creditworthiness of the company.

Like other types of bonds, debentures are documented in an indenture. An indenture is a legal and binding contract between bond issuers and bondholders specifying features of a bond, such as its maturity date, the timing of interest payments, the method of interest calculation, and other features.

Debentures are used by corporations as long-term loans, which pay an interest rate, and are repayable on a fixed date. A company typically makes these interest payments prior to paying out dividends to its shareholders, similar to most debt instruments. 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.

• A debenture is a type of debt instrument that is not secured by collateral. Debentures are backed only by the creditworthiness and reputation of the issuer.
• Both corporations and governments frequently issue debentures to raise capital or funds.
• There are many features of debentures, some of which can convert to equity shares while others cannot. Debentures pay an interest rate or coupon rate and typically have long-term maturities of more than ten years.

Convertible debentures are bonds that can convert into equity shares of the issuing corporation after a specific period of time. Convertible debentures are hybrid financial products with the benefits of both debt and equity. Companies use debentures as fixed-rate loans and pay fixed interest payments. However, the holders of the debenture have the option of holding the loan until maturity and receive the interest payments or convert the loan into equity shares.

Convertible debentures are attractive to investors that want to convert to equity if they believe the company's stock will rise in the long-term. However, the ability to convert to equity comes at a price since convertible debentures pay a lower interest rate compared to other fixed-rate investments.

Nonconvertible debentures are traditional debentures that cannot be converted into equity of the issuing corporation. To compensate for the lack of convertibility, investors are rewarded with a higher interest rate when compared to convertible debentures.

When issuing a debenture, first a trust indenture must be drafted, which 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. The interest 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.

Credit Rating

The company's credit rating and ultimately the bond's or debenture's credit rating impacts the interest rate that investors will receive. Credit-rating agencies measure the creditworthiness of corporate and government bonds to provide investors with an overview of the risks involved in investing in bonds.

Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a rating below BB is considered to be speculative grade or a junk bond, which means it is more likely to default on loans.

Maturity Date

For nonconvertible debentures, the date of maturity is also an important feature since it dictates when the 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.

The interest rate paid on a debenture might not keep up with inflation. Inflation is a measure of price increases throughout the economy. If prices rise by 3% and the debenture pays 2%, investors have a net loss in real terms.

Debentures carry interest rate risk, which occurs when interest rates are rising, and investors are holding fixed-rate debentures at lower interest rates. As a result, a debenture holder might earn a lower yield compared to the market in a rising-rate environment.

Debentures carry credit risk and default risk since they're tied to the issuer's financial viability. If the company struggles financially due to internal or macroeconomic factors, investors are at risk of default on the debenture. As some consolation, a debenture holder would be repaid before common stock shareholders in the event of bankruptcy.

An example of a government debenture would be the U.S. Treasury bond (T-bond). The U.S. government issues bonds to raise money to finance projects or day-to-day operations. The U.S. Treasury Department issues bonds via auctions at various times throughout the year. Some Treasury bonds or Treasuries can trade in the secondary market whereby investors can buy and sell previously issued bonds through a financial institution or broker. Treasuries are considered risk-free since they're backed by the full faith and credit of the U.S. government.

Treasury bonds are long-term bonds with maturities between 10 to 30 years. T-Bonds provide semi-annual interest payments and have $1,000 face values. The 30-year Treasury bond yield closed at 2.817% on March 31, 2019.