Debentures are important sources of finance for large companies. They help companies raise capital or funds in order to run their businesses more efficiently. Besides that, companies do not use a debenture to invest their profits. And this is just like other types of bonds, they document them in an indenture.
Debentures do not have collateral. Just like loans without collateral where they do not require an asset as a backup for loans. As you read along, you’ll know more about debenture, how it works, its features and so on.
What is a Debenture?
A debenture is a type of bond or other debt instrument that corporations do not secure by collateral. Because of this, they rely on the creditworthiness and reputation of the issuer. Corporations and governments usually issue it to raise capital or funds. Debentures that have fixed rates of interest can help companies raise funds. So, debenture holders are, therefore, creditors of the company.
In other terms, it is an acknowledgement of the organization’s debt to the public. Therefore, a company issues it to admit that the company has borrowed an amount of money from the public. And they promise to repay it on a future date. It helps businesses to raise long-term debt capital.
How do debentures work?
Having known the meaning of debentures, you would need to know how they work. It is through an agreement they call an indenture that the borrower issues them. This agreement specifies specifics such as the loan amount, convertibility, interest rate, and maturity date. However, this depends on the country of issue. Thereafter, the investor lends the money to the borrower with the expectation of return at the interest rate they agreed on.
Case study of debentures
This case study will help you have a better understanding of what debentures are all about.
If a company X in Ghana issues a GH₵100,000 debenture that matures on December 30, 2025. This is the date the company expects to receive the loan back. And it has a 5% interest per year, payable on 30 September every year. Then, an investor agrees to offer the loan at a fixed charge. If company X defaults on the payment, the investor may now sell the company’s assets. They’ll sell these assets in order to raise the capital they need to fulfil the loan.
What are the features of a Debenture?
Debenture has essential features investors or the issuers must note. When companies issue it, they will first draft a trust indenture. And this trust represents an agreement between the issuing corporation and the trustee that manages the interest of the investors.
The following are its features:
1. Interest Rate
They determine the coupon rate, which is the rate of interest that the company will pay its holder or investor. This coupon rate could either be fixed or floating. They may tie a floating rate to a benchmark such as the yield of the 10-year Treasury bond. Because it’s floating, it will also change as the benchmark changes.
2. Credit Rating
This credit rating has to do with the company’s credit rating. However, its credit rating affects the interest rate that investors will receive. Credit-rating agencies assess the creditworthiness of government and corporate issues. They give investors the overview of the risks in debt investment.
3. Maturity Date
The maturity date is essential because it dictates when the company must pay back its holders. The company has options on the form to choose from and it will help arrange how the repayment will take place. However, it is a redemption from capital, in which the issuer pays a lump sum payment upon the debt’s maturity.
Alternatively, they could make the payment via a redemption reserve. Reserve in which the corporation pays certain sums each year until they fully repay the loan at the maturity date.
The types of debenture charge
It can grant one or both of the following charges, with lenders typically seeking one or both of them.
1. Fixed charge
The fixed charge helps a lender to ensure it’s the first creditor to recoup any outstanding debt. Especially if a borrower cannot repay a loan. It gives a lender control and ownership of a borrower’s asset when the borrower cannot repay. Then the lender will use the money from the sales of the asset to repay the outstanding debt. It is very common for fixed charge to be against property.
A fixed charge can cover building fixtures, trade fixtures, etc as well as covering the freehold or leasehold of a property. With a fixed charge, the borrower cannot sell the asset without the lender’s approval. And they typically direct the revenues to the lender or use it to purchase a new asset. Which is the asset the lender places a fixed charge on.
2. Floating charge
They can attach a floating charge to all of a company’s assets, or specific classes of asset. These assets include stock, raw materials, debtors, vehicles, fixtures and fittings, cash, and even intellectual property. Because the charge is ‘floating,’ these assets may change over time, with the borrower having the ability to shift or sell any assets in the normal course of business.
When the lender attempts to enforce it in a default situation, the floating fee “crystallizes” and effectively becomes a fixed charge. The borrower won’t be able to deal with the assets in question. Unless the lender gives them permission to do so. A floating charge gives a lender priority over unsecured creditors for payback allocation in an insolvency or liquidation.
3. Multiple debentures
Multiple debentures on the same borrower are workable for a lender or lenders. These could either be multiple fixed debentures against different specific assets, multiple floating debentures, or a mixture of both. When a company’s first lender issues it, they frequently block a second lender from issuing another without their permission.
When many lenders have debentures having recourse against the same borrower’s assets. Then they will agree on a payment priority. And they frequently use a Deed of Priority to document this between the lenders and the borrower.
Types of Debenture
There are types of debenture for lenders and borrowers to explore. They include:
- Secured and Unsecured: A secured debenture imposes a charge on the company’s assets, effectively mortgaging the company’s assets. An unsecured debt does not charge or secure the company’s assets.
- Registered and Bearer: They record a registered debenture in the register of debenture holders of the company. And they require a regular instrument of transfer for their transfer. Whereas bearer debentures are debentures, they can transfer simply by delivery. A registered debenture is one that they enter the company’s debenture holder registry. For their transfer, they require a regular instrument of transfer. Whereas bearer debentures are debentures, they can transfer simply by delivery.
- Convertible and Non-Convertible: After the expiry of a specific period, they can convert a convertible debenture into equity shares. Whereas non-convertible debentures are those that they cannot convert into equity shares.
- First and Second: The first debenture is the one they repay before the other. Whereas the second debenture is the one they pay after the repayment of the first debenture.
What are the pros and cons of debentures?
Debentures have their pros and cons; they’ll guide both borrowers and lenders in making specific goal-oriented decisions.
The following are their pros:
- They pay investors a regular interest rate, sometimes known as a coupon rate.
- Convertible debentures are more appealing to investors because they can convert it to equity shares after a specific period.
- Companies pay debentures before common stockholders in the event of a corporation’s insolvency.
- Investors who desire a steady income with less risk prefer them.
- Because they do not have voting rights, financing through them does not reduce control of equity shareholders authority on management.
- Because the interest paid on them is tax deductible, financing through them is less expensive than financing through preference or equity capital.
- The company does not use them to invest its profits.
- When sales and earnings are typically consistent, they are a good financing option.
The following are their cons:
- When the market interest rate is rising, it may expose fixed-rate debentures to interest rate risk.
- Creditworthiness is essential when considering the chance of default risk from the underlying issuer’s financial viability.
- They may be subject to inflationary risk if the coupon payments do not keep pace with inflation.
- Each company has a specific amount of borrowing power. When they issue debentures, it reduces the capacity of the company to borrow further capital.
- With a redeemable debenture, they required the firm to make plans for repayment on the designated date, even if the company is experiencing financial difficulties.
- With redeemable debenture, the company has to make provisions for repayment on the date they specified. Including periods the company faces financial difficulties.
- They permanently constrain the earnings of a company. Because of this, there is a bigger risk when the company’s earnings fluctuate.
Is a debenture different from a bond?
A debenture is a sort of debt instrument companies or other entities issue as an unsecured or non-collateralized debt. And it typically refers to bonds with longer maturities.
Are debentures risky investments?
Debentures are less risky than investing in the same company’s common stock or preferred stock because they are debt securities. With bankruptcy, they’ll regard holders of debentures as more senior and prioritize them over other types of investments. These debts, however, are riskier than secured obligations because they do not back them by any collateral. Because of this, interest rates on them may be higher than on other identical collateral-backed bonds from the same issuer.
How are debentures structured?
They structure all debentures in the same way, and they have the same qualities.
The following is the structure of a debenture:
- Preparation of a trust indenture, which is an agreement between the issuing business and the entity that manages the bondholders’ interests.
- They then determine the coupon rate, or the interest rate that the corporation will pay the debenture holder or investor.
- This rate could be a fixed or floating rate and they determine it by the credit rating of the company or the bond.
- To common stock, debentures can be convertible or non-convertible.
Is debenture good or bad?
Debentures are a fundamental part of raising capital for a firm. Without debenture, some lenders won’t lend more than a specific amount. Therefore, no matter how much you want to borrow, prepare to put your assets up as collateral.
If you don’t want to risk putting your company’s assets on the line, an unsecured loan may be a better fit for you, even if it means borrowing less and paying a higher interest rate.
Companies issue debentures when they lack cash flow. Especially when they need to raise capital along with other long-term finance sources. Companies will always prefer to issue the debenture with fewer troubles. This is the reason they will need to follow the regulations and procedures that come along with issuing debentures. Besides that, they must ensure that the debenture bears the features discussed in this article.