DEFINITION: A debenture is a type of bond or other debt instrument that has no collateral security.
Since debentures are not backed by assets, the reputation of the issuer is the principal factors providing the credibility that makes them attractive to investors.
Debentures are commonly used by both corporations and governments as a way of raising capital or liquid funds.
Much like conventional bonds, debentures may provide regular interest payments known as “coupon payments.”
ETYMOLOGY: The English word “debenture” is attested from the fifteenth century. It derives from the Middle English term debenture, which is the third-person plural, present tense, passive voice form of the Latin verb dēbeo, dēbēre (“to owe,” “to be morally bound to X,” “to be due to X”), meaning “they are due.”
USAGE: Debentures are legally constituted through a contract called an “indenture.” An indenture, in this sense of the term, is a binding agreement between the issuer of the debenture and its holders.
The indenture includes the principal features of a debenture offering, including such determinations as the maturity date of the instrument, the interest payment (coupon) schedule, the method of interest calculation, and other similar specifications.
Governments typically opt for debentures in the form of long-term bonds (those with maturities exceeding 10 years). These government bonds are considered low-risk investments since they are backed by the issuing government itself.
Corporations use debentures essentially as long-term loans. However, unlike secured bonds, debentures rely solely on the financial strength and creditworthiness of the issuing company.
Debentures offer companies several advantages compared to other forms of loans and debt instruments, including lower interest rates and longer repayment periods.
Kinds of Debentures
Registered vs. Bearer: Debentures can be issued in two forms: registered or bearer.
Registered debentures are publicly recorded in the name of the issuer, and any transfer of these securities must proceed via a clearing facility. This process ensures both that the issuer is aware of sales of its debentures and that the issuer is able to make interest payments to the correct holder.
Bearer debentures, on the other hand, are not registered in the name of the issuer. The owner of the bearer debenture, also known as the “bearer,” is entitled to interest simply by holding the bond, without the need for any formal registration or notification process.
Redeemable vs. Irredeemable: Redeemable debentures explicitly specify the terms and date on which the bond issuer must fully repay its debt. In contrast, irredeemable (non-redeemable) debentures do not impose any obligation on the issuer to repay the debt by a specific date. For this rerason, irredeemable debentures are also known to as “perpetual debentures.”
Convertible vs. Nonconvertible: Convertible debentures are bonds that can convert into equity shares of the issuing corporation after a specified period of time.
Convertible debentures are hybrid financial products, which offer the benefits of both debt and equity.
On the one hand, companies use debentures as fixed-rate loans and pay fixed interest payments. On the other hand, the holders of convertible debenture have the option of either holding the loan until maturity and receiving the interest payments or of converting the loan into equity shares.
However, the flexibility of convertible debentures involves a trade-off, as these securities typically yield a lower interest rate than other fixed-rate investments.
Nonconvertible debentures are debentures that lack the option to be converted into the issuing corporation’s equity. To offset this lack of flexibility, nonconvertible debentures offer their holders a higher interest rate than do convertible debentures.