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Key Takeaways
- A debenture is a type of bond that’s unsecured by collateral.
- Debentures rely on the issuing company’s reputation and creditworthiness.
- They can help companies raise capital without diluting their equity.
- Debentures come in many types and may be convertible to shares.
As part of a series of guides about financial instruments, we explain what debentures are and how they may be useful to your business.
What is a Debenture?
A debenture is a debt instrument that is unsecured by collateral. These instruments are legal certificates issued by companies in order to find financing. As they have no backing with physical assets, debentures depend on a company’s reputation and credit. Typically, only organizations that are highly trusted and have excellent credit can successfully raise financing through debentures, in contrast with secured debts like bonds.
Debentures are usually considered long-term debt for a company and show up in this section on a company’s balance sheet. Typically, debentures are issued with maturity dates of either five or ten years. However, like many bonds, they usually pay interest in regular payments called “coupon payments” that are scheduled in a debenture agreement. The issuing company pays the interest in full through these payments and then pays back the debenture holder’s capital investment when the debenture matures.
Debentures are different from secured bonds in that they’re unsecured by collateral. Debentures also differ from shares because the money raised from them doesn’t become share capital. Debenture holders also don’t gain voting rights or any other form of control over the issuing company.
In terms of debt structure, debentures are paid after secured debt but before preferred shares if a company declares bankruptcy.
Types of Debentures
Like bonds and shares, debentures come in different types based on different characteristics. These types include:
- Convertible vs. Non-convertible Debentures: Convertible debentures can be changed into shares of the issuing company’s equity after a set period. The holders of these debentures may opt to convert them into shares instead of receiving their capital at maturity. However, the flexibility of convertible debentures makes them pay lower interest rates than non-convertible debentures that can’t be changed into shares.
- Registered vs. Bearer Debentures: As with bonds, debentures can be registered to specific owners who are the only ones who can redeem them. These owners’ names are kept in a registry, and when the debentures are exchanged, the registry must record the new owner’s name. A bearer debenture, on the other hand, can be redeemed by anyone who holds the debenture certificate.
- Redeemable vs. Irredeemable Debentures: Redeemable debentures specify the precise date of maturity or when the debt must be repaid. Irredeemable debentures, however, have no date specified and rely on the issuing company to repay the debt when it can.
- Corporate vs Government Debentures: When corporations raise capital by issuing an unsecured debt, it’s called a corporate debenture. However, governments can raise taxes to pay back debts and, therefore, also issue debts unsecured by collateral. These government debentures include Treasury bonds and Treasury Bills, which are technically unsecured.
Comparison of Key Debenture Characteristics
| Feature | Convertible Debentures | Non-Convertible Debentures | Risks/Considerations |
|---|---|---|---|
| Equity Impact | May convert to shares | Never converts | Convertible may dilute equity later |
| Interest Rate | Lower (due to conversion value) | Higher | Higher rates compensate investors |
| Investor Rights | No voting rights before conversion | No voting rights | Equity control unaffected initially |
| Collateral | Unsecured | Unsecured | Dependent on issuer credit risk |
| Return Profile | Potential upside via conversion | Fixed return only | Limited upside compared with equity |
Advantages and Risks of Debentures
As with all investment instruments, debentures come with their own distinct advantages and disadvantages. These must be weighed by investors who may choose to own some debentures to diversify their portfolios.
Benefits for Investors and Issuers
- Non-dilution: Companies can issue debentures to raise capital without diluting their equity. Issuing debentures to raise capital may enable a company to avoid issuing shares altogether, keeping it as a privately held entity.
- Low-risk: While not as low-risk as bonds which are backed by collateral, debentures pay regular coupon payments before maturing. These returns gradually reduce the risk of the investment over time. Debentures are also repaid before common stock in case of bankruptcy.
- Convertible to shares: In cases where convertible debentures are issued, they give investors the option to convert them to shares at a later date. This flexibility can increase the attractiveness of the instrument and allow investors to take advantage of performance gains by the company.
Potential Risks and Drawbacks
- Unsecured: Debentures, unlike bonds, are not backed by collateral. This means that they’re riskier than bonds, though they’re also typically offered at higher interest rates. An investor must depend on the issuer’s creditworthiness and reputation to trust debentures.
- Limited rate of return: Debentures can have either a fixed or floating interest rate. Compared with share prices, however, they will never double or increase exponentially. Investors, therefore, risk missing out on other opportunities that may produce higher returns.
- Inflation: The coupon interest paid may not keep up with inflation rates, which means investors could actually face the risk of a net loss in real terms.
Issuing and Investing in Debentures
Companies interested in issuing debentures should have their credit and financial statements in order. They need to plan out their financial needs and predict their ability to pay back their investors. They can then decide how many debentures to issue, their value, and their structured repayment plans.
Investors should only consider companies with excellent reputations and credit when investing in debentures. These investments can help them moderate their risk exposure as part of a diversified portfolio.
Debentures offer lower-cost capital than equity but create fixed payment obligations that constrain financial flexibility during downturns, requiring careful maturity matching against cash-flow stability. China corporate services specialists at MSA Asia help evaluate whether debt financing aligns with your cash flow profile. Contact our team to assess your financing mix.
Need funding without diluting your ownership? Speak with our corporate finance experts to explore debentures and tailored debt strategies that align with your growth plans. Message →
FAQ
A debenture is a medium- or long-term debt issued by a company or government agency as a means of securing financing. A bond is the same, except that while a bond is backed by physical assets or other forms of collateral, debentures are not backed by collateral. They are, therefore, considered higher-risk and paid at a higher rate of interest.
A typical debenture agreement will indicate how much a debenture holder is owed. It will also detail a maturation date, the timing and amount of coupon payments, and a clear statement of the calculation of interest.
