A debenture is an instrument of debit or a bond that enables an entity, either a corporation or a government, to attract a huge amount of capital with no pledge for any specific collateral. Unlike secured bonds, debentures are wholly dependent on the credit rating and reputation of the issuer, hence making it quite a different but somewhat riskier investment opportunity. Types available are convertible, non-convertible, registered, and unregistered ones. All these varieties bring flexibility, carrying their distinguishing features and benefits to suit the needs of different investors. The different types of debentures, their features, associated risks, and examples are all discussed in this blog to give a clear insight into this very important financial tool.
What Is a Debenture?
A debenture is a non-collateral bond instrument. These debentures are not secured thus their worth is directly related to the issuer's creditworthiness and reputation. Debentures are widely issued by corporations and governments to obtain capital or provide collateral for funding.
Types of Debentures
Here are the different types of debentures:
Convertible Debentures
Convertible debentures are those instruments of debt that are convertible into equity shares of the borrowing company, under certain specified conditions, providing a chance for investors to participate in the equity of the company.
Non-Convertible Debentures
Non-convertible debentures are not convertible into equity shares. In this type, regular interest on their investment is received by the investors, but they do not have any option of converting their investment into the stock of the company.
Registered Debentures
Registered debentures are recorded in the books of the company that issues them and have to be transferred through a clearing facility so that interest on these bonds reaches the correct bondholder.
Unregistered Debentures
Unregistered debentures, also known as bearer debentures, have no maintenance of records of holders by the issuer, which makes them very easy to transfer. Ownership is determined by possession, not registration.
Redeemable Debentures
Redeemable debentures are those where the principal amount has to be returned to the debenture holder on a specific date, usually at the end of life, and thus the debt obligation comes to an end.
Irredeemable Debentures
Irredeemable debentures do not carry any fixed redemption date. They are payable only at the time of liquidation of the company and continue to yield interest to the holder indefinitely.
Features of a Debenture
The most popular form of debt instrument, which a company can issue for raising its capital, is through the use of debentures. Some key features of debentures are enumerated below:
Fixed Interest Rate: Normally, it has a fixed interest rate that periodically is payable to debenture holders; hence, this makes them very attractive to those investors who want to earn regular income out of investments
Maturity Period: Debentures generally have a maturity period; at the end, the principal amount is returned by the company to the investors. The maturity period might be of a few or more than a few years.
Secured vs. Unsecured: The debentures are either secured or unsecured. In the case of secured debentures, some assets of the company act as security for the investors. Unsecured debentures are those that do not have any collateral backing; for example, naked debentures are a form of unsecured loan.
Convertibility: A few debentures are convertible into equity shares of the company after a period of time. This feature enables the investors to reap the benefits from the growth of the company.
Tradability: The Debentures can generally be sold in the secondary market. This provides liquidity to the investors.
Priority in Repayment: In the case of winding up of the firm, the debenture holders have priority over shareholders in getting their money back. Therefore, these are comparatively a safer investment than equity.
Risks to Investors while investing in debentures
There are many risks the debenture holders are exposed to: inflationary risk, interest rate risk, and credit or default risk.
Inflationary risk: This risk arises when the interest paid on the debenture remains below the rate of inflation, expressing the rise of the general price level of goods and services in the economy. For example, when prices go up by 3%, the debenture pays an interest of only 2% and the real value of investment falls.
Interest Rate Risk: When investors hold fixed-rate debentures during rising market interest rates. On rising market rates, the fixed return on the debenture is less attractive than that obtained from other new investments that pay higher rates. The holders of the debenture therefore earn lower yields relative to what they could otherwise get.
Credit and Default Risk: Since debentures are essentially unsecured, their value depends on the ability of the issuer to pay. If the company-issuer falls into financial trouble, either due to performance or conditions relating to the general economy, then there is a possibility of default. Hence, debenture holders can suffer losses in such a scenario, though they would have priority over common equity holders in case of liquidation.
Example of a Debenture
An example of a debenture is the **convertible debenture issued by Tesla, Inc.** In 2017, Tesla issued convertible debentures worth $1.8 billion to raise capital for its operations and growth. These debentures were convertible, meaning that holders had the option to convert their debenture holdings into Tesla shares at a specified conversion rate after a certain period. The debentures paid a fixed interest rate, and the conversion feature provided an opportunity for investors to benefit from Tesla's potential growth.
Another example is **the U.S. Treasury bond**, which is technically a debenture because it is not secured by any specific collateral but is backed by the "full faith and credit" of the U.S. government. These bonds are considered very low-risk investments due to the government's strong creditworthiness.
Debentures like these allow companies and governments to raise capital while offering investors regular interest payments, with varying degrees of risk depending on the issuer's financial stability and market conditions.
Conclusion
Debentures are a significant way of raising capital in corporate and governmental sectors. They provide the investor with an opportunity for a regular interest income stream, associated with their respective levels of risk. Though lacking collateral backing, their risk can often be mitigated by the creditworthiness of the issuer. Be it the option of equity conversion in convertible debentures or steady returns from non-convertible ones, the varieties of debentures adjust to different investment strategies by both individual and institutional investors.
For those looking to diversify their investment portfolio further, Compound Real Estate Bonds are a low-risk way for generating fixed income at an attractive 8.5% APY. These bonds, backed by real estate and U.S. Treasuries, give investors flexibility in the form of anytime withdrawals with no fees and additional features like auto-investing and round-ups for spare change, making them a great companion to traditional debenture investing.
