Debentures: Meaning, types, advantages & disadvantages

What is a debenture?

A debenture is a sort of bond or other obligation instrument that is unstable by guarantee. Debentures may be secured with collateral or not, when secured, they can also be floating or fixed. Debentures are frequently issued by governments and corporations to raise funds or capital.

A debenture is a type of debt instrument that typically has a term of more than ten years. Put simply, debentures are documents or instruments evidencing an obligation owed by the company to the debenture holders. This instrument is often but not necessarily by deed; this is more so because the CAMA 

Types of debentures

Redeemable and Irredeemable debentures

Redeemed Debentures clearly define the precise conditions and due dates by which the bond’s issuer must repay their debt in full. On the other hand, non-redeemable (irredeemable) debentures do not obligate the issuer to repay the entire amount by a predetermined date.

Perpetual debentures are another name for irredeemable debentures. The irredeemable debenture can also be made redeemable on the occurrence of an event or the happening of a contingency, no matter how remote.

Convertible and non-convertible debentures

Convertible debentures are financial instruments that combine the advantages of equity and debt. Debentures are used by businesses as loans with fixed interest rates. However, the holders of the debenture have the option of converting the loan into equity shares or holding the loan until maturity to receive interest payments.

If investors believe that the company’s stock will rise over the long term, then convertible debentures are a good option for those who want to convert to equity. Nonetheless, convertible debentures pay a lower interest rate than other fixed-rate investments, so the ability to convert to equity comes at a cost.

Traditional debentures that cannot be exchanged for equity in the issuing company are known as nonconvertible debentures. When compared to convertible debentures, investors are rewarded with a higher interest rate to make up for the lack of convertibility.

Secured and unsecured debenture

Secured dentures are debenture instruments backed with assets of the company as collateral. For instance, AGV Ltd obtains a loan from JFG Ltd and offers its asset as security for the loan, such is regarded as a secured debenture.

An unsecured debenture is also known as a naked debenture, here there exists no asset security for the debenture.

Characteristics of a debenture

Before a debenture can be issued, a trust indenture must be written. The agreement that governs the investors’ interests in the first trust is between the issuing corporation and the trustee.

Interest rates

The company’s interest rate that the holder of a debenture or investor will receive is known as the coupon rate. The rate of this coupon can be either fixed or floating.

A drifting rate may be attached to a benchmark, for example, the yield of the 10-year Depository security, and will change as the benchmark changes.

Credit rating and due diligence

The interest rate that investors will receive is influenced by both the credit rating of the company and, ultimately, the credit rating of the debenture. Investors are provided with an overview of the risks associated with investing in debt by credit-rating agencies, which measure the creditworthiness of corporate and government issues.

Letter grades are typically given by credit rating agencies like Agusto and Co., DataPro Limited, or Global Credit Rating to indicate a company’s overall creditworthiness. Any debt instrument with a rating below BB is considered to be of speculative grade3—you may also hear these referred to as junk bonds—under the Standard & Poor’s system, which employs a scale that ranges from AAA, which indicates an excellent rating, to the lowest possible ratings of C and D. It all comes down to the fact that the primary issuer is more likely to fail to pay the debt.

Maturity date

The maturity date of the aforementioned nonconvertible debentures is also an important feature. The company must repay the holders of debentures by this date. The company can choose how the repayment will be done. It typically occurs as a redemption from the capital, in which the issuer makes a one-time payment when the debt reaches maturity. 

Advantages of debentures

1. Investors receive a regular or coupon rate return on a debenture.
2. After a predetermined time, convertible debentures can be converted into equity shares, making them more appealing to investors.
3. Debentures take priority in the event of a company’s bankruptcy or winding up.

Disadvantages of debentures

1. When the market interest rate rises, fixed-rate debentures may expose investors to interest rate risk.
2. When considering the risk of default posed by the underlying issuer’s financial viability, creditworthiness is crucial.
3. If the coupon paid does not keep up with the rate of inflation, debentures may be subject to inflationary risk.
4. The three principal elements of a debenture are the financing cost, the credit score, and the development date.

The U.S. Treasury bond (T-bond) is one example of a debenture issued by the government. T-bonds aid in project financing and daily government operations funding. These bonds are issued by the Treasury Department of the United States at auctions held throughout the year.

The secondary market is where some Treasury bonds are traded. Investors can purchase and sell previously issued bonds on the secondary market through a broker or financial institution. Because they are backed by the full faith and credit of the United States government, T-bonds are almost risk-free. However, they are also susceptible to inflation and rising interest rates.

Are debentures dangerous investments?

Since debentures are obligation protections, they will generally be safer than putting resources into a similar organization’s normal stock or favored shares. Debenture holders would likewise be viewed as more senior and take need of those different kinds of interests.

However, these debts are inherently riskier than secured debts because they lack collateral. As a result, these might have slightly higher interest rates than other bonds from the same issuer that are similar and secured by collateral.

Both a U.S. Treasury bond and a U.S. Treasury bill are, in point of fact, debentures. Even though they are not backed by collateral, they are regarded as risk-free securities. In Nigeria, the government has issued debentures in the form of bond issuance and the like.

Conclusion

Debentures are a typical type of unstable bond given by organizations and states. Unsecured bonds, in contrast to secured bonds, which are backed by collateral, are somewhat riskier because they do not provide any kind of asset protection if the issuer defaults: They only rely on the issuer’s creditworthiness. A U.S. Treasury bond is, strictly speaking, a debenture in this sense.

Frequently Asked Questions (FAQs)