Debentures

Definition

Debentures are a type of debt instrument issued by companies or governments to raise capital, representing a loan made by an investor to the issuer. They are typically long-term securities that pay fixed interest over a specified period and are backed by the issuer's creditworthiness rather than physical assets. This means that debenture holders are creditors to the issuer and have a claim on its income and assets in the event of liquidation, although they stand behind secured creditors.

5 Must Know Facts For Your Next Test

1. Debentures are usually issued for a fixed term, ranging from several years to decades, with specific maturity dates when the principal must be repaid.
2. The interest paid on debentures is known as a coupon payment, which is typically made semi-annually or annually, providing predictable income to investors.
3. Debentures may have different classifications such as registered or bearer debentures, affecting how they are transferred and recorded.
4. Unlike secured loans, debentures are unsecured and rely on the creditworthiness of the issuer; therefore, they usually offer higher yields than secured debt instruments.
5. In case of bankruptcy or liquidation, debenture holders have priority over equity shareholders but are subordinate to secured creditors when it comes to asset claims.

Review Questions

• How do debentures differ from secured bonds in terms of risk and investor return?
  • Debentures differ from secured bonds primarily in their risk profile. Secured bonds are backed by specific assets, offering investors lower risk due to collateral protection in case of default. In contrast, debentures are unsecured, relying solely on the issuer's creditworthiness, which generally leads to higher interest rates offered to compensate for the additional risk investors assume. This distinction is crucial for investors looking to balance potential returns against their risk tolerance.
• Discuss the implications of issuing convertible debentures for both the issuing company and investors.
  • Issuing convertible debentures allows companies to raise capital while offering investors an attractive feature that could lead to equity ownership. For companies, this means lower initial interest payments compared to regular debt instruments since investors value the conversion option. For investors, convertible debentures provide an opportunity for capital appreciation if the company's stock performs well while still offering fixed interest income if they choose not to convert. This dual benefit can enhance investment attractiveness but may also dilute existing shareholder equity if conversions occur.
• Evaluate how market conditions affect the pricing and yields of debentures in relation to interest rates and investor demand.
  • Market conditions significantly influence the pricing and yields of debentures. When interest rates rise, existing debentures with lower coupon rates become less attractive, leading to price decreases and higher yields for new issuances. Conversely, in a declining interest rate environment, existing debentures may increase in price as their fixed coupon payments become more valuable relative to new issues. Additionally, investor demand plays a critical role; high demand can drive prices up and yields down, while low demand can lead to price drops and increased yields. Thus, understanding these dynamics is essential for investors considering debenture investments.

Related terms

Bonds:

Bonds are debt securities similar to debentures, often secured by specific assets or revenues, providing investors with interest payments over time.

Interest Rate: The percentage of the principal amount charged by lenders to borrowers for the use of money, which is essential for determining the yield on debentures.

Convertible Debentures: A type of debenture that can be converted into a company's equity at the option of the debenture holder, usually at a predetermined conversion rate.