You may need a long-term loan, but you don’t want to put up any real assets as collateral. If your credit is good, you may qualify for a debenture.
What Is a Debenture?
A debenture is a bond that is not backed by an asset (collateral). Debentures wholly depend on the creditworthiness and reputation of the issuer and are one of the most common long-term loans. This type of bond usually has a term of 10 years or more.
If a corporation goes bankrupt, the debenture must be paid off before paying common stock shareholders. Debentures are registered in an indenture, which is a binding contract between the issuer and holder. The indenture includes the features of the agreement, interest rate, interest method and more.
Governments often provide and use debentures because with a government’s innate creditworthiness, these bonds are seen as low-risk investments. Companies also use debentures, but the financial health and creditworthiness of a company will be taken into account before the debenture is issued. A corporation could be denied a debenture due to bad financials or a lack of creditworthiness.
Debentures must also be repaid or redeemed by a fixed date previously agreed upon, accounting for interest rates. Oftentimes, a company will agree for the debt to be paid before they pay dividends to shareholders.
When creating a debenture, a first trust indenture must be made. Within this agreement, interest rates, credit rating and a maturity date must be agreed upon. These are the three main features of a debenture.
Due to debentures being fixed-rate, bond holders may face inflationary risk. This would be the case if the agreed upon interest rate doesn’t keep up with inflation. For example, if inflation is 5% and the debenture interest rate is only 3%, the debenture issuer will assume the risk, losing out of 2%.
That risk can also work the other way round, putting investors at interest rate risk, which happens if inflation is lower than the agreed upon interest rate.
What Are the Different Types of Debentures?
There are two types of debentures: convertible and nonconvertible.
Convertible debentures are bonds that can convert into equity shares of the issuing corporation, after an agreed upon period. If the debenture holder, or borrower, keeps the loan until the agreed time (without paying it off), the holder can either receive interest payments or equity shares.
On the other hand, non-convertible debentures cannot be converted into equity. These debentures usually have higher interest rates.