Understanding Debentures

Key takeaways
* A debenture is an unsecured debt instrument issued by corporations or governments that relies on the issuer’s creditworthiness rather than pledged collateral.
* Debentures pay periodic interest (coupons) and have specified maturities; some are convertible into equity.
* Major risks include credit/default risk, interest-rate risk, and inflation risk. In bankruptcy, debenture holders rank ahead of shareholders.

What is a debenture?

A debenture is a long-term, unsecured debt instrument (a type of bond) used by corporations and governments to raise capital. Because it is not backed by specific collateral, its value depends on the issuer’s reputation and credit strength. Debentures typically pay regular interest and return principal at maturity, although terms vary.

How debentures work

• Issuance: Terms are set out in an indenture (a legal contract) that specifies maturity, coupon schedule, interest calculation, covenants, and other conditions.
• Payments: Issuers make periodic coupon payments to holders and repay principal at maturity (if redeemable).
• Priority: In insolvency, debenture holders are creditors and are paid before equity shareholders, but after secured creditors if the debenture is unsecured.

Types of debentures

Registered vs. Bearer
* Registered debentures record the owner with the issuer; interest is paid to the registered holder.
* Bearer debentures do not record ownership; the physical holder receives interest.

Redeemable (term) vs. Irredeemable (perpetual)
* Redeemable debentures have a fixed redemption date when principal must be repaid.
* Irredeemable or perpetual debentures do not have a fixed redemption date and may pay interest indefinitely.

Convertible vs. Nonconvertible
* Convertible debentures can be exchanged for the issuer’s equity under defined terms; they typically offer lower coupon rates in exchange for conversion upside.
* Nonconvertible debentures cannot convert to equity and generally pay higher coupons.

Key features to evaluate

• Coupon rate: Fixed or floating; floating rates often track a benchmark (e.g., a government yield).
• Credit rating: Assigned by rating agencies; higher-rated issuers pay lower interest. Ratings indicate default likelihood.
• Maturity and repayment terms: Lump-sum redemption, sinking-fund schedule, callable features, etc.
• Indenture and trustee: Legal agreement and trustee protect bondholders’ interests.

Pros and cons

Pros
* Regular income through coupons.
* In bankruptcy, debenture holders have priority over shareholders.
* Convertibles offer potential equity upside without immediate dilution.

Cons
* No collateral backing—higher credit/default risk than secured debt.
* Fixed-rate debentures suffer when market interest rates rise.
* Coupon payments may not keep pace with inflation.

Main risks for investors

• Credit/default risk: Issuer may fail to make interest or principal payments.
• Interest-rate risk: Market rates rise → market value of fixed-rate debentures falls.
• Inflation risk: Real returns decline if coupons do not keep up with inflation.
• Liquidity and market risk: Secondary-market trading may be limited for some debentures.

Examples and comparisons

• U.S. Treasury bonds are technically unsecured debt (debentures) backed by the government’s credit and treated as effectively risk-free, though still exposed to inflation and interest-rate risk.
• Secured bonds differ from debentures by having specific collateral that creditors can claim in default, making secured debt generally safer and cheaper for issuers.

Structure and accounting perspective

• Issuer’s view: A debenture is a liability—borrowed capital to be repaid with interest.
• Investor’s view: A debenture is an asset that produces interest income and may appreciate or depreciate in market value.

Bottom line

Debentures are a common way for entities to raise long-term funds without pledging assets. They offer predictable income and creditor priority over equity but carry issuer-dependent credit risk and sensitivity to interest rates and inflation. Evaluate coupon structure, maturity, credit rating, and convertibility before investing.