A debenture is a long-term debt instrument issued by corporations and governments to secure fresh funds or capital. There is no collateral or physical assets required to back up the debt, as the overall creditworthiness and reputation of the issuer suffice. Coupons or interest rates are offered as compensation to the lender.
Examples of government-issued debentures are Treasury bonds and Treasury bills. These are considered risk free due to the fact that the government can pay back the amount owed, getting the resources from taxes. Corporate debentures are most commonly used for long-term loans, which have a fixed date for repayment as well as a fixed interest rate.
What are the Different Types of Debenture?
There are two main types of debentures that can be issued:
#1 Convertible debentures
Interest-bearing bonds that can be converted from debt into equity shares after a specific period of time. This is a special feature that corporations take advantage of because it can attract lenders and usually carries a lower interest rate for the issuing company.
#2 Non-convertible debentures
Regular debt instruments that are not convertible into equity shares. However, to attract lenders and investors, these come with higher interest rates.
Important Factors to Consider when Buying a Debenture
Before investing in debentures, investors or lenders need to weigh these vital points:
#1 Credit rating
There are various agencies that assess credit ratings in order to gauge the quality of a bond in terms of credit performance. A high rating of AAA or AAA+ is preferred.
#2 Coupon rate
This is the interest rate offered by the issuer. A higher rate implies higher risk debt instruments, and a lower rate means lower risk debt instruments. Coupon payouts can be made monthly, quarterly, semi-annually, or annually.
#3 Issuer’s credibility
The financial health of the company or issuer is still the best judge of creditworthiness. Having knowledge of why additional funds/ capital are needed, as well as the credit rating, are the most important factors when making the decision to invest.
#4 Additional perks or features
These are special features added to promote a product or attract investors, some of which are given to A-listers – those who have a significant financial position in society. Companies may offer a profit-sharing plan to employees as a type of debenture.
What are the Pros and Cons of a Debenture?
There are two important points of view to consider when evaluating the pros and cons of debentures:
#1 The Issuer
From the issuer’s point of view, a convertible bond can be considered advantageous, as the bond can be offered at a lower coupon rate than the coupon of a straight bond. Moreover, the bond interest is a deductible expense for the issuing company, meaning it will be taxed less, as compared to issuing equity.
Regardless of how much profit the company is generating, convertible bondholders can only receive fixed limited earnings until conversion, meaning the company can only share operating income with them if the business is doing well.
#2 The investor
For investors or lenders, convertible bonds provide a security blanket for their money, especially for those who are eager to participate in the potential growth of a company. Once bonds are converted into equity shares, the investors or lenders can benefit from the increase in the market price of stock shares.
Although they are riskier than convertible bonds in terms of market volatility, non-convertible bonds offer a higher interest rate or yield to bondholders. When interest rates rise, however, the value of the bond drops. Since these cannot be converted to equity shares, the only option is to wait until the maturity period.
Thank you for reading this guide to understanding what a debenture is and what the pros and cons are from an investment perspective. CFI is the official global provider of the Financial Modeling and Valuation Analyst designation and is on a mission to help you Advance Your Career. To keep learning and advancing your career, these CFI resources will be helpful: