A debenture is a type of unsecured bond or similar debt instrument. It is unsecured, i.e. not secured by collateral. Anyone wanting to invest in debentures must rely solely on the issuer’s creditworthiness.
It is common for both corporations and governments to issue debentures to raise capital, and one of the most famous examples is the U.S. Treasury bonds issued by the United States government.
To gauge an issuer’s creditworthiness, it is common for investors to turn to credit rating agencies such as Standard and Poor´s. If the issuer´s credit rating is low, investors will require a fairly high interest rate to be willing to take the risk of investing. If the credit rating is high, a debenture can be attractive to investors even if it does not come with a high interest rate.
Standard and Poor´s system use a scale ranging from AAA to D, where AAA is the highest possible credit rating and anything below BB is considered “speculative grade”.
For redeemable debentures, the maturity date of the debenture is specified in the debenture contract (indenture). The maturity date is when the issuer must pay back the money to the debenture holder.
Most debentures have a term (lifespan) greater than 10 years, but it is possible to issue debentures with a shorter term than this. There are also debentures that have no maturity date.
Lump sum or incremental repayments
Depending on the terms and conditions of the debenture contracts, an issuer can pay back the debenture holder either in the form of a lump sum payment on the maturity date or by repaying specific amounts of money each year until the final debenture repayment is made upon the date of maturity.
For a redeemable debenture, the terms and date by which it can be redeemed is specified in the contract, i.e. the how and when the issuer of the debenture must repay the debt in full. Irredeemable (also known as non-redeemable) debentures do not have this feature and do not hold the issuer liable to repay in full by a certain date. This type of debentures are also known as perpetual debentures.
To make debentures more appealing to investors, the issuer will typically create debentures that pay periodic interest payments – so called coupon payments.
If you are interested in investing in corporate debentures, check in advance if the corporation is obliged to make the debenture interest payments before paying any stock dividends to shareholders.
Free vs. floating interest rate
The interest rate (also known as coupon rate) can be fixed or floating. A floating rate is typically tied to a benchmark, e.g. the 10-year U.S. Treasury bond yield.
It is possible for a corporation to issue debentures that can be converted into equity (company shares) in the corporation after a certain amount of time.
Typically, conversion can only happen if the owner of the debenture requests it – the issuer can not force a conversion since such terms would make the debenture much less desirable to investors.
A convertible debenture is considered a hybrid financial product, as it is both a debt contract and a kind of share option. In most cases, convertible debentures come with a fixed interest rate, and it is common for convertible debentures to pay a lower interest rate than other fixed-rate investments.