Definition of Debentures
A corporation or company can generally borrow money by issuing debentures or bonds. A debenture or bond is a written acknowledgment by a company or corporation of a loan made to it.
It is issued to money lenders under the seal of the corporation. It contains a contract for the repayment of the principal sum at a specified date and the payment of interest at a fixed rate until the principal sum is repaid.
Difference Between Issuing Debentures and Shares
A company raises money by issuing shares. Debentures are one way in which a company can raise long-term finance.
The primary difference between issuing debentures and shares is that debentures are loan instruments and not equity instruments and represent a loan to be repaid by the company with interest at a fixed rate. On the other hand, shares represent ownership interests and voting rights.
Debenture holders are creditors of the company, while shareholders are owners of the company.
When a company issues debentures, it borrows money and incurs a liability. When a company issues shares, it sells ownership interests and does not incur liability.
Features of Debentures or Bonds
If you purchase a bond, you will receive a bond certificate. This certificate spells out the terms of an agreement between the issuer and the investor.
These terms include the denomination or principal of the bond, its maturity date, the stated rate of interest, the interest payment terms, and any other agreements made between the borrower and lenders.
Denomination of the Bond
Individual bonds usually have a denomination of $1,000. However, in recent years, $5,000 and $10,000 bonds have become more common.
This article will assume that all bonds are in $1,000 denominations unless otherwise stated.
A total bond issue usually contains several hundred or thousands of individual bonds. For example, a $10 million bond might consist of 10,000 individual $1,000 bonds. Investors can purchase as many of these individual bonds as they wish.
After a large publicly held company issues bonds, they trade on the New York Bond Exchange. It enables present and potential investors to sell and purchase bonds after their initial issue, just as they do with shares of stock.
The date that the bond principal is to be repaid is called the maturity date. Bonds usually mature within 5 to 30 years from their issue date.
Bonds whose entire principal is due in one payment are called term bonds, and bonds that are payable on various dates are called aerial bonds.
Stated Interest Rate and Interest Payment Dates
Most bonds have a stated interest rate that is part of the bond agreement. This rate is often referred to as the nominal interest rate; it is specified on the bond when it is issued. The nominal interest rate does not change over the life of the bond.
The firm’s management fixes the stated interest rate in conjunction with its financial advisers. They attempt to set the rate as close as possible to the market interest rate that exists when the bond is issued.
The market rate is the money market’s interest rate through hundreds of individual transactions. The market rate is dependent on factors such as the prevailing interest rates in the economy and the perceived risk of the particular company.
Most bonds pay interest semi-annually (i.e., every six months). However, the stated interest rate is an annual rate based on the face value of the bond.
For example, a $1,000, 12% bond that pays interest on 2 January and 1 July will pay interest of $60 ($1,000 x .12 x 6/12) on each of these dates until it matures. In effect, the bond in this example pays 6% interest every six months.
Bondholders are unable to vote for corporate management or otherwise participate in corporate affairs in the way that common shareholders do. As a result, bondholders often insist on written covenants as part of the bond agreement.
These agreements are referred to as bond indentures. While they can take various forms, they usually include restrictions as to dividends, working capital, and the issuance of additional long-term debt.
These agreements aim to ensure that the borrower will maintain a strong enough financial position to meet the interest and principal payments.
Types of Debentures or Bonds
Simple or naked debentures or bonds
Simple debentures are those carrying no security as to the payment of interest or repayment of the principal sum. The holders of these are considered insecure, so these are not popular in the present day. Simple debentures are also called naked debentures.
Mortgage debentures or bonds
Mortgage debentures are secured by a charge on the corporation’s assets, such as plants, machinery, equipment, land, and buildings. Mortgage debentures are of the following two types:
First mortgage debentures
First mortgage debentures are those for which the holders have the first claim on the assets charged.
Second mortgage debentures
Second mortgage debentures are those for which the holders have a second claim on the assets charged.
Bearer debentures or bonds
The amount of bearer debentures is payable to the bearer. They are negotiable instruments and are transferable by mere delivery.
Registered debentures or bonds
The names and addresses of these debenture holders are recorded in the corporation’s books. Transfer of these debentures must be registered in the books of the corporation, as in the case of shares. Interest is paid to registered holders.
Redeemable debentures or bonds
These are debentures that are repayable at the end of a specified period. They are issued subject to the corporation’s condition to redeem them on a specified date. These debentures are very common nowadays.
Irredeemable debentures or bonds
These debentures are never repayable during the existence of the corporation. That is to say, they are only repayable on the corporation’s liquidation.
Convertible debentures or bonds
These debentures may be converted into ordinary shares or preference shares of the company. This option is given to the debenture holder for the period mentioned in the conditions of the issue.
A debenture is a long-term loan that a company raises by issuing bonds. Debentures are backed only by the creditworthiness and reputation of the issuer. It distinguishes them from secured loans, such as mortgages or car loans, backed by collateral. Debentures are also called unsecured loans.
The interest rate on a debenture is usually lower than the rate on a secured loan, reflecting the higher risk involved. Corporations and governments generally issue it to raise capital.
The primary advantage of debentures for the issuing company is that they represent a relatively low-cost form of borrowing. The key disadvantage for debenture holders is that they are at the bottom of the queue for repayment if the company goes bankrupt, ahead only of unsecured creditors such as suppliers.
Debenture holders also do not have voting rights in the company, unlike shareholders.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.