Debentures are often the alternative name of unsecured bonds. It can be any debt instrument without collateral. It is the form of issuing debt without pledging any assets as collateral. Large companies and government institutes issue debentures to raise funds from capital markets.
What is Debenture?
A debt instrument that is unsecured and comes without collateral is called a debenture. Unsecured bonds without collateral are often termed debentures.
Large companies and government institutes issue such bonds to raise capital. These bonds do not pledge any assets as collateral. The bond issuers’ creditworthiness counts as the only collateral.
Bond indentures also provide security to bondholders. Indentures are legally binding contracts for bond issuers and bondholders. These contracts specify important terms of debenture such as interest rate, maturity date, covenant attached, and call features. Its interest rate largely depends on the credit rating of the bond. Since there is no collateral, the bond rating usually comes through the credit rating of the issuer.
How Does it Work?
Government institutes and large corporations often issue it to raise capital. These debentures are bonds issued without collateral. They can be any other unsecured form of debt as well. Usually, the term is used for unsecured bonds issued without pledging any assets.
Large companies issue it to raise finance for the long-term. It is usually issued for more than 10 years of the maturity date. Like ordinary bonds, the issuer also writes a bond indenture. The indenture secures the financial interests of both parties and fulfills the regulatory requirement.
It can take several forms depending on the purpose. Corporations often use it as a form of long-term loans. Although it comes without collateral they are deemed secured as the issuers enjoy high creditworthiness.
Characteristics of a Debenture
Debenture commonly refers to unsecured bonds. However, it can also come with collateral backing in some countries. Also, the term debenture can be used for other unsecured loans as well.
Here are a few key features of it.
- It does not offer collateral in the backing as compared to bonds.
- The only pledge for debentures is the creditworthiness of the issuer.
- Companies often issue it to raise funds for specific purposes such as projects and expansions.
- The repayment can be in one large repayment or installments.
- Unlike bonds, it can offer floating or fixed interest rate options.
- The credit rating of its issuer plays an important role in deciding the interest rate.
Types of Debentures
Bond debentures can take several forms depending on their function and needs of the bond issuer.
Here are some common types:
Convertible Debentures
Convertible bond debenture can be converted to equity through shares on maturity. Investors have the option of receiving full repayment on maturity or convert it to company stocks. Investors can feel more secured with convertible bonds. it offers hybrid features of equity and debt.
Non-Convertible Debentures
Non-convertible debentures cannot be converted into equity on maturity. Investors only receive the invested amount as repayment. The repayment of the principal amount can be in one lump sum or installment amounts. These bonds offer higher interest rates to investors as compared to convertible bonds.
Fixed and Floating Interest Rate Debentures
Traditional bonds often offer fixed interest rates only. Debenture bonds can offer fixed or floating interest rates. Both options offer varying benefits to investors.
Investors prefer fixed interest rates for long-term investments such as unsecured debentures. Bond issuers may offer higher floating interest rates to attract large investments.
Perpetual Bond Debentures
Some bond debentures come with no expiration or maturity date. These bonds are said to be perpetual in nature. Large corporations and government institutions issue such bonds with high credit ratings. Perpetual bond debentures are termed as equity instruments rather than debts.
Pros
It offer several advantages to issuers as well as investors.
- It is an unsecured form of debt, yet offers financial security to investors due to the high credit ratings of issuers.
- They can come with several features such as convertibility to allow further flexibility to issuers.
- They offer tax benefits to issuers for raising funds as compared to equity.
- Investors can feel secure as in the case of bankruptcy, the holders will be preferred over common stockholders.
Cons
Debentures also offer some limitations to issuers and investors:
- Issuers require high credit ratings since debentures do not offer collateral.
- Fixed interest rates can come with inflation risk in the long-term.
- Since it is issued for the long-term, they can face interest rate risk for investors and issuers.
Conclusion
Debentures are unsecured forms of debt, usually bonds. They can be issued without collateral. The credit rating of the issuer decides the bond rating. They can be converted to equity on maturity.
