Debentures are considered as a type of bond or a debt instrument that is not secured by collateral. It is similar to most bonds but usually pays interest payments periodically. These payments are known as coupon payments. Since there is no collateral backing, debentures usually rely on the creditworthiness and the positive reputation of the issuer.
Just like other bonds, debentures are also documented as a legal and binding contract between the issuing and holding parties who are known as bond issuer and bondholder. This document with the terms and conditions of the bond is known as indenture. Indenture specifically mentions the below details.
– Features of the debt offering
– maturity date of the bond
– coupon payment or interest payment time
-interest calculation method
-special features and conditions
Both governments and corporations frequently issue debentures whenever they want to raise funds or whenever there is a capital need.
The debentures issued by governments are usually mature after more than 10 years. Those are known as long-term bonds. Government-issued debentures are considered as a low-risk investment as there is security due to the backing of the government issuer of the debenture.
Treasury bonds and treasury bills are examples of government-issued debentures.
Treasury bonds – Treasury bonds (T-bonds) are the type of debentures issued by the government with a maturity period of more than 20 years. These earn periodic interest until maturity, at which point the owner is also paid a paramount equal to the principal amount.
Treasury bills – Treasury bills are short-term debentures issued by the government treasury department with a maturity of one year or less. Treasury bills are usually sold in the denomination of $1,000.
The main difference between treasury bonds and treasury bills is the maturity time period.
Corporate-issued debentures are often used for long-term loans. These have a fixed repayment date and a fixed interest rate.
There are two main types of debentures issued.
01. Convertible debentures – These are bonds that have the possibility of converting into equity shares of the debenture-issued corporation after a specific time period. Corporations use this special feature to attract lenders and it also helps to issue debentures at a lower interest rate.
Convertible debentures can be identified as hybrid financial products as they provide benefits of both debt and equity. Corporations often use debentures as fixed-rate loans that pay with a fixed interest rate. However, the holders of the debentures carry the option of holding the loan until the date of maturity and receiving the interest payment. They also have the option of converting the loan amount into equity shares.
Convertible debentures have the possibility of attracting investors when there is a possibility of the stock price rise in the company stocks in the long run. However, it is also identified that the interest rate paid for the convertible debentures is lower than other fixed-rate investments available in the market.
02. Nonconvertible debentures – These are the traditional debentures that do not have the ability to convert into equity of the issuer corporation. They have the possibility of keeping the debenture until maturity and receiving the interest. As a reward for not being able to convert into equity shares, nonconvertible debentures carry a higher interest rate compared to convertible debentures.
Being able to receive a fixed interest rate or a coupon rate as a return and less risk is considered as the advantage of the debentures. However, it is identified that there are several disadvantages to investing in debentures.
Not being secured by collateral, inflationary risk, and interest rate exposures in the environment where the market interest rate is rising for fixed-rate debentures can be identified as disadvantages of investing in debentures.