What is a Debenture?

A debenture is a type of financial security that a business issues to investors in order to obtain long-term financing from these investors without needing to put up any collateral as in a traditional loan.

The business also does not have to issue new shares in order to raise capital. In this way, the shareholders do not dilute their equity in the business.

What Types of Businesses Issue Debentures?

It is a type of long-term business debt that is often an appropriate funding option for businesses in good financial standing that do not want to issue shares to new investors that would dilute the equity of previous shareholders.

Debentures are also ideal for businesses that may not have adequate collateral to obtain a traditional loan.

Debentures are primarily issued by public companies and private companies of significant size.

Debenture Certificate

The debenture certificate is a legal document that details the following information:

  • Loan Amount
  • Interest rate, called the coupon rate
  • Repayment or Redemption schedule to repay the interest and principal
  • Maturity date
  • Credit rating of the debenture
  • Seniority of repayment – when the debenture will be repaid relative to other creditors in the event of bankruptcy or liquidation of the business
  • Convertibility of the debenture to other securities such as Common or Preferred shares of the business

Investors generally receive the Principal back at the Maturity Date. This is at the end of the term of the debenture.

Prior to this Maturity Date, the business only pays the interest to the investor.

The full Principal loan amount is repaid on or after the Maturity Date.

Unique Liquidity Feature of a Debenture

Unlike a traditional loan, a debenture is a marketable security, which means that it can be traded from investor to investor. That is, the debenture holder can sell the debenture to another investor. This is why it is called a marketable security.

As noted above, debentures are securities often issued by public companies. For this reason, corporate debentures are traded on stock exchanges.

Since debentures are a form of debt on a balance sheet, debenture holders have priority over shareholders. Debenture holders get paid before shareholders.

Thus, a debenture holder assumes less risk than a shareholder because the debenture interest payments are paid out before dividends on shares are ever paid, if any dividends are actually even paid.

Convertible Debentures

An additional advantage that debenture holders have for investing in debentures is that debentures can be convertible.

This means that a debenture holder has the right but not the obligation to convert its loan into shares of the issuing business under the conditions set out in the debenture certificate.

A debenture can also be partially convertible, which means part of its value can be converted into shares and part of it into cash.

This convertible feature is a sweetener added to the investment offering to encourage investors to invest in the debenture, which is a higher-risk long-term loan since it has no collateral attached to it.

Common Terms of a Debenture

Maturity: Debentures generally have a maturity of 5 to 10 years.

Interest Rate: Since the debenture is not secured by collateral and therefore carries higher risk, the business issuer usually offers a higher interest rate than they would pay for a secured loan or bond.

Seniority: In the event of a bankruptcy or liquidation of the business, debenture holders are paid after secured debt holders such as banks.

However, debenture holders are paid before common and preferred shareholders.

The debenture seniority relative to other unsecured debt holders depends on how the debentures were negotiated between the business and the debenture investors.

Debentures on the Balance Sheet

Debentures are accounted for as part of Long-term Debt in the Liabilities on the balance sheet.

They are usually placed under Non-Current Liabilities. These are liabilities with a maturity date of more than 1 year.

The debenture interest payments would, of course, be accounted for under Interest Expenses in the Income Statement of the business.

In public filings made by listed companies, the Notes to the Financial Statements will normally note the debentures that the business has issued.

How to Redeem Debentures

Debentures may be redeemed or repaid as follows:

  • Lump-sum payment of interest and principal on maturity
  • Instalment payments such as annual or semi-annual or other instalment schedule
  • Full or partial conversion into common or preferred shares or rolled over into a new debenture

Differences Between Debentures and Bonds

Debentures and bonds can both be long-term debt financing but they have some differences including:

  • Debentures can be secured or unsecured. Bonds are almost always secured.
  • Debentures are long-term debt. Bonds can be long-term or short-term debt.
  • Debentures can be convertible. Bonds are generally not convertible.
  • Debentures are a subordinate debt to Bonds.

Differences Between Debentures and Traditional Loans

The main difference between a debenture and a traditional loan is that a debenture is almost always unsecured with no collateral. On the other hand, a traditional loan can be secured or unsecured.

Secondly, a debenture is issued by the business itself that is seeking the loan from investors. Whereas, a traditional loan is issued by a lender that is offering the loan to the business.

Since a debenture is not secured by any collateral, the business that is issuing the debenture must have high creditworthiness and sufficient cash flow to be able to repay the loan over the long term.

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