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? Here is its definition, meaning, types, and examples.
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 utilize 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.
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.
There are a couple of main types of debentures, including:
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.
The main differences between these debentures are:
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.
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.
No investment is risk free, and there are always benefits and drawbacks to each. Here are the primary ones for debenture investing:
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.
Take the alternative investment platform Yieldstreet, on which more than $3.2 billion has been invested since its inception (as fo July 2023). Yieldstreet offers the most expansive selection of highly vetted alternative asset classes, including art, real estate, legal finance, and private credit.
In fact, private market alternatives are becoming an essential part of the modern portfolio. Diversifying ones holdings beyond the stock market can reduce volatility and overall risk. Spreading ones investments across varying assets can make experiencing large losses less likely.
Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.
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Debenture and other alternative investments are important to consider as a way to diversify holdings – critical to successful investing — and help protect them against volatility and inflation. And while no investment is risk free, they could also generate steady secondary income.
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