Debentures are a type of debt instrument that are not secured by specific property or collateral, but are backed by the full faith and credit of the issuer. If the issuer were to liquidate, the debenture holder is considered a general creditor, and has a claim on any assets not specifically pledged to secure other debt. Debentures are frequently issued by large corporations and governments to raise capital. Companies that are exceptionally creditworthy and have never defaulted on any of their other debt, do not feel the need to pledge their assets to attract investors. Debentures issued by governments are considered risk-free. Treasury bonds and Treasury bills are generally considered risk free because governments, at worst, can raise taxes or simply print more money in order to redeem the debentures at maturity.
Key Features:
- Debentures are certificates of indebtedness that contain the name of the investor, and mention the terms and conditions wherein the interest rate and the par value of each debenture is shown.
- Debentures are usually long-term loans that are repayable on a fixed date. Some debentures are irredeemable securities (also called perpetual debentures), and are paid back only when the company goes into liquidation.
- In the event of liquidation of a company, debenture holders stand prior to owners of preference shares and ordinary equity shares.
- The rate of interest paid to the debenture holders may be fixed or floating. Most debentures pay a fixed rate of interest. The interest paid to debenture holders is calculated as a charge against the company’s profit.
- Issuers are required to pay interest to the debenture holders before they can make any dividend payments to shareholders.
- Debenture holders have no right to vote in the company’s general meetings of shareholders. They may however have separate meetings or votes to decide on specific issues such as changes to the rights attached to the debentures.
- In the United States, a debenture refers specifically to an unsecured corporate bond. However, in the United Kingdom, a debenture is usually a secured loan instrument.
- Like other types of bonds, investors can purchase debentures through brokers. Companies often issue debentures of around $1,000, while government bonds are usually in $5,000 denomination.
- Subordinated debentures are unsecured bonds that rank after secured debt, general debenture bonds, and often after some general creditors in their claim on assets and earnings. Issuers offer higher interest rates and even the option to convert to shares in some cases, to lure investors into such kind of debt.
Types of Debentures:
Based on convertibility, there are two types of debentures:
- Convertible debentures: Such type of debentures can be converted into equity shares of the issuing company after a pre-determined period of time. The terms and conditions of conversion are generally announced at the time of issue. Convertible debentures typically have lower interest rates than non-convertible bonds, but are more attractive to investors.
- Non-convertible debentures: Holders of such debentures do not have the right to convert debt into equity shares of the liable company. To compensate for the non-convertibility, lenders are usually offered a higher rate of return compared to convertible debentures.
Debentures allow companies to raise money from the public without diluting ownership. Also, they are usually repayable at a date, far-off in the future. Debentures help to reduce the burden of corporate income tax, since interest is charged against the profit and loss account. During period of inflation, the issue of debentures may be advantageous because the obligations of paying interest and principal decrease in real terms as the price level increases. For an investor, their main advantages are that they are often easy to sell in stock exchanges and are less risky than equities.
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