Debenture Explained: Favorable Investment Opportunity

January 11, 20247 min read
Debenture Explained: Favorable Investment Opportunity
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Key Takeaways

  • Debentures are not backed by collateral, and their support is dependent upon the issuer’s reputation and credit worthiness.
  • Governments and corporations often use debentures to fund major expansions and projects over the long term.
  • While not without risk, debentures can present a favorable investment opportunity since they frequently pay higher interest rates than other kinds of bonds.

Debentures are particularly popular among investors looking to make investments outside the general stock market, as they can help diversify investment holdings and could potentially pay a regular interest rate. But what is a debenture? Let’s take a look at how it’s defined and what types of debenture exist.

What is a Debenture?

In the U.S., a debenture is some form of unsecured bond or other debt instrument. Because the securities are not backed by collateral, their support is dependent upon the issuer’s reputation and creditworthiness.

Also, governments and corporations often use debentures to fund major expansions and projects over the long term. Governments usually issue long-term bonds with maturities that exceed 10 years. Government bonds, considered low-risk, are backed by the government’s issuer.

While corporations use debentures as long-term loans as well, they are unsecured here. That means their support is based on the underlying company’s creditworthiness and financial viability. Companies tend to favor debentures since the securities carry lower interest rates and longer repayment periods when sized up against other loan types. 

What Else is There About Debentures?

Debentures, which may make periodic interest payments, as with other bonds, are documented in what is called an indenture. That is a legal contract between bond holders and issuers that specifies debt offering features such as its interest calculation method, payment timing, and maturity date.

Types of Debentures

There are a couple of main types of debentures, including:

  • Convertible vs. Non-Convertible. Convertible debentures are bonds that, after a set period, can convert into equity shares of the issuing corporation. Note that these debentures are hybrids in that they offer the benefits of equity as well as debt.

Companies commonly use debentures as fixed-rate loans, and, as such, pay fixed-interest payments. However, there will be an option to convert the loan into equity shares or hold the loan until maturity and get interest payments.

In particular, convertible debentures lure investors who, if they think the company’s stock will ultimately rise, wish to convert to equity. A caveat, though, is that compared to other fixed-income investments, debentures pay a lower interest rate.

Meanwhile, nonconvertible debentures are traditional in that conversion of the issuing corporation’s equity is not allowed. Such lack of convertibility is offset by an interest rate that is higher than convertible debentures.

  • Secured vs. Unsecured.  In essence, whereas secured debentures are backed by the issuing company’s assets, unsecured debentures lack the backing of any specific asset.  So, secured debentures are secured by a charge on a company’s assets, but unsecured debentures are not.

The main differences between these debentures are:

  1. Risk. Because secured debentures are asset-backed, they are generally viewed as less risky than their unsecured counterparts. Should default occur, those with secured debentures have better odds, through the sale of the company’s assets, of recovering their investment. Note, though, that those with unsecured debentures have no claim to specific assets should default occur. So, such investors are more exposed to risk.
  2. Security. These debentures are backed by the issuing company’s assets while unsecured debentures are not backed by specific assets. This means that unsecured debentures are not secured by a charge on the company’s assets.
  3. Priority. Should corporate liquidation occur, those with secured debentures are more likely to get repaid than holders of unsecured debentures. So, if the company goes bankrupt, holders of secured debentures will be prioritized over those with unsecured debentures.
  4. Collateral. Assets are needed for secured debentures, while debentures require no such collateral. Because companies do not have to put up any specific assets, it is easier for them to issue unsecured debentures.

In all, the chief difference between secured and unsecured loans is the level of risk and security for investors. While secured debentures are generally viewed as less risky but carry lower interest rates, there is more risk, but the potential for higher returns, with unsecured debentures. 

Characteristics of Debentures

There are certain characteristics that are common to debentures, including:

Interest rate. There is a determination of the coupon rate – the rate of interest the company must pay the investor or debenture holder, and which can be fixed or floating. A floating rate may be linked to a benchmark and will change as the benchmark changes. The benchmark could be, for example, the yield of a 10-year Treasury bond.

Credit rating. The interest rate that investors will get is impacted by the company’s credit rating, and thus, the debenture’s credit rating. Such creditworthiness is assessed by credit-rating agencies, which reveal risk findings to investors.

Maturity date. The maturity date is an important feature of nonconvertible debentures since it directs the date on which the company must repay debenture holders. While the company will usually have options, in terms of the form of repayment, it typically will have the issuer pay a lump sum when the debt matures.  

Debt instruments. Debentures are basically debt financial instruments that are issued by private companies. However, they are not backed by physical assets or any other collateral. They are known as debt instruments because they are used by companies to raise cash with a promise of repayment after a certain period.

Transferability. The debenture holder may freely transfer debentures. While such holders have no voting rights in shareholder meetings, they may have separate votes or meetings on changes to rights attached to debentures.

Pros and Cons of Debenture Investing

No investment is risk free, and there are always benefits and drawbacks to each. Here are the primary ones for debenture investing:

Pros:

  • Diversification. As an alternative investment, investing in debentures serves to diversify investment portfolios, which mitigates overall portfolio risk.
  • Lower volatility. Because debentures have less correlation to public markets, they are generally less volatile.
  • Fixed income. As debt instruments, fixed-income securities pay investors a fixed amount of interest, or coupon payments.

Cons:

  • Interest rate risk. Fixed-rate debentures may be at interest rate risk in environments of rising market interest rates. In other words, investors here hold fixed-rate debts when market interest rates rise. Such investors may see lower debt returns, resulting in the debenture holder earning a relatively lower yield.
  • Default risk. As has been stated, debentures’ security is commensurate with the financial strength of the underlying issuer. Investors are at risk of default on the debenture if the company struggles financially because of macroeconomic or internal factors. Note, though, that debenture holders are prioritized for repayment in the case of bankruptcy. 

Role of Debentures in the Financial Market

  1. Investment opportunity. In general, many experts believe that debentures present a favorable investment opportunity since they frequently pay higher interest rates than other kinds of bonds.
  2. Risk management. Since debentures are debt securities, they generally tend to be less risky than taking positions in the company’s preferred shares or common stocks.

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There are other kinds of alternative investments, which essentially are any assets other than stocks, bonds, or cash. They are increasingly popular, too, as private markets have outperformed stocks during every economic downturn of the past 15 years.

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Summary

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