Introduction
Like people, corporations and governments may on occasion find themselves running short on funds in which case they need to make use of debt instruments. Debentures happen to be one such instrument that are employed in order to raise money. This article seeks to explain all that debentures account for.
Debentures: Meaning
A debenture can be categorized as a debt instrument or a bond that isn’t secured by any collateral. Owing to this very fact, debentures are reliant on creditworthiness and the reputation tethered to their issuer. Corporations, as well as governments, employ debentures fairly regularly in order to raise capital or funds.
Examining Debentures from a Microscopic Lens
In the same fashion as most bonds, those who issue debentures are required to pay interest payments periodically. These payments are called coupon payments. Further, like most bonds, debentures are recorded under an indenture. This is a legal and binding contract that is signed by bond issuers and bondholders. This contract makes apparent the features tethered to this debt offering. Features here refer to the maturity date, the time frame of interest or coupon payments, and the manner in which interest will be calculated among others.
Governments ordinarily tend to issue long-term bonds that have maturities that exceed 10 years. These bonds are by and large viewed as low-risk investments as they are backed by the government who is responsible for issuing them.
Corporations also employ debentures to serve as long-term loans. That being said the debentures issued by corporations are unsecured. Their primary backing is in the form of financial viability and creditworthiness tethered to the underlying company. Debenture holders are paid an interest rate on a periodic basis. Moreover, these debt instruments can be redeemed or repaid on an outlined date. Ordinarily, companies that issued debentures make scheduled debt interest payments prior to paying their shareholders any stock dividends. The advantages associated with debentures pertain to the fact that they hold lower interest rates for the company and have longer time frames for repayment in comparison to other forms of loans or debt instruments.
Convertible vs. Nonconvertible Debentures
Convertible debentures refer to those bonds which can be converted into equity shares for the corporation that issued the debentures following a certain time frame. Such debentures can be categorized as hybrid financial products that provide their owners with the perks associated with debt and equity. Companies often make use of debentures as they would fixed-rate loans and pay predetermined interest payments. That being said, the holders of these debentures are given the choice to either hold onto the company’s loan until maturity and receive interest payments or convert the same into equity shares.
Convertible debentures appeal to investors who seek to convert to equity if they are under the impression that the company’s stock will gain more value over the long term. That being said, converting from debt to equity comes with a price as convertible debentures pay their owners a smaller interest rate in comparison to other fixed-rate investments.
On the flip side, nonconvertible debentures are more traditional and cannot be converted into the issuing corporation’s equity. In order to offset this lack of convertibility, investors are provided with larger interest rates in comparison to convertible debentures.
Features of a Debenture
When looking at debentures in accounting, the primary agenda pertains to drafting a trust indenture. This agreement is then signed by the issuing corporation and the trustee that is responsible for managing the interest of the investors.
All debentures have the following features.
Interest Rate:
A coupon rate, which serves as the rate of interest paid by the company to the debenture holder, is decided and made clear in the trust indenture. This rate may be fixed or floating. In the case of the latter, it may be tethered to a benchmark and changes in accordance with changes in the benchmark.
Credit Rating:
Interest rates received by investors are dependent upon the credit rating of a company and its debenture’s credit rating. Credit-rating agencies are responsible for measuring the creditworthiness of bonds issued by corporations and governments. These agencies are responsible for providing investors with a broad understanding of the risks associated with investing in debt.
Maturity Date:
In the case of nonconvertible debentures the date of maturity is worth noting. This date makes clear the time by which the company is required to pay back those that hold debentures. The company has a number of options they can follow in order to issue this repayment. More often than not this payment is made by redeeming the capital and involves the issuer paying a lump sum amount once the debt acquires maturity. Else, the payment is made with a redemption reserve which involves the company paying certain sums each year until they have paid back the entire amount by the date of maturity.
Concluding Thoughts
Debentures bring them advantages as well as disadvantages. In terms of the former, they pay regular interest rates to investors and in the case of convertible debentures, their appeal lies in the fact that they can be converted into equity following a certain amount of time. That being said, the drawbacks of debentures pertain to inflationary risks. Further, since they are subject to creditworthiness, the risks associated with them are significant.
