Debenture Bonds

An unsecured, long term loan.

What is a Debenture?

A debenture is a long-term debt instrument issued by corporations and governments, primarily to secure fresh funds or capital. There is no collateral or physical assets needed 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 Two Types of Debentures?

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.

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.

What are the Important Factors to Consider in Buying Debentures?

Before investing in debentures, investors or lenders need to weigh these vital points:

  • Credit rating – there are various agencies that can 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.
  • Coupon rate – this is the interest rate offered by the issuer as a reward. 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-annual or annually.
  • Issuer’s credibility – the financial health of the company or issuer is still at the best judge. 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 investment.
  • Additional perks or features – there 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 offer a profit-sharing plan to employees as a type of debenture.

What are the Pros and Cons of Debentures?

In the issuer’s point of view, a convertible bond is considered advantageous, as the bond can be offered at a lower coupon rate.  This is less than that of a straight bond. Moreover, the bond interest is a deductible expense for the issuing company, meaning it will be taxed less. 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. For investors or lenders, convertible bonds provide a security blanket on their money, especially for those who are eager to participate in the potential growth of a company. Once this is converted into equity shares, the investors or lenders can benefit from the increase in market price of stock shares.

Although they are riskier than convertible bonds in terms of market volatility, non-convertible bonds give a higher interest rate or yield to bondholders.. Interest rates tend to 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.

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