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What is Debenture?


The term 'Debenture' is included in the Corporate Finance edition of the Financial Dictionary. Get yours now on mazon in ebook or paperback format. Read more here...

A Debenture refers to a form of debt instrument. The differentiating factor of such instruments is that they do not have the physical backing of either collateral or assets securing them. Instead, they are only guaranteed by the overall reputation and creditworthiness of the issuing corporation or municipality. Governments and corporations alike commonly issue such bonds in order to obtain much needed fresh capital. As with other forms of bonds, these are recorded in indentures.

Since such Debentures come without any collateral, the buyers of bonds purchase them on the hopes that the issuer will not default on interest and principal repayments. Government examples of these kinds of bonds abound in the marketplace. T-bills and T-bonds are both classic debentures. They have always been deemed to be completely risk free as the government can always raise taxes to pay its debt obligations or resort to printing money in order to cover them.

Corporations most often resort to issuing Debentures as their longer term loan vehicles. They typically come with a maturity date that is fixed at an interest level that is similarly fixed. Corporations will most often make such interest payments ahead of giving any dividends to the stock shareholders, as with other types of senior debt obligations. This makes debentures beneficial with their lower interest rate and farther away repayment date as compared to other forms of debt bonds and loans corporations and governments can take out.

Two forms of Debentures exist. These are either non-convertible or convertible ones. The convertible ones represent bonds that the holders can convert into stock shares from the issuer once a pre-set time period has elapsed. Investors like these kinds of bonds more than others since they gain the ability to convert to more lucrative and price appreciative stock. Issuers appreciate them best since they come with the lowest of interest rates.

Alternatively, the non-convertible types are more regular Debentures which cannot be exchanged for stock in the issuer. The compensation for this lack of flexibility in the instrument is that they come with a higher interest rate than their non-convertible debenture cousins.

Every debenture on the market comes with particular characteristics. The trust indenture must be drafted. This agreement is set up between the managing trust and the issuing corporation. The coupon rate must subsequently be determined, as it is the critical interest rate which the firm will pay the investors and debt holders. While the rate is often fixed, it may also be floating. This comes down to how high the firm’s credit rating or the credit rating of the bond issue itself proves to be.

With non-convertible debentures, the maturity date turns out to be among the key features of the issue. Maturity date is the point when the issuer has to return the principal to the investors. Yet the firms possess several options for how they will repay this money. It is most common for companies to do a redemption from their capital. This means that the issuers will simply offer a lump sum one-time payment on the maturity date. The second choice is known as the debenture redemption reserve. In this form, the issuer is allowed to transfer a set quantity of funds every year up to the point where the debenture has been fully repaid into the fund by the maturity date.

With either way, the company or government agency still repays all funds due on the maturity or repayment date. The only difference lies in whether they set aside the funds in part ever year or have to front them all entirely in the year they are due to be repaid.

The term 'Debenture' is included in the Corporate Finance edition of the Financial Dictionary. You can get your copy on mazon in Kindle or Paperback version. See more details here.