Debentures are often compared to bonds, but in reality, debentures are just a particular type of bond. While bonds are backed by collateral, debentures are not backed at all.
Let’s compare the differences between debentures and bonds and find out which is a better investment option for you.
What is a Debenture?
A debenture is a type of bond that’s not secured by collateral.
Most bonds are backed by some type of collateral. If the borrower can’t pay back the loan, then the borrower’s assets may be sold to pay back the lenders. Collateral is a good form of protection for investors.
For example, a corporation may issue a bond to raise revenue for a new product line. Company real estate is used as collateral—perhaps two or three valuable properties that the company owns. If the corporation cannot pay back the bond to investors, it would sell the properties and use the proceeds to pay investors.
But debentures are not backed by any form of collateral. If the borrower can’t pay back a loan, investors may not get the rest of their money back. That makes them riskier than traditional bonds. but they also have their advantages.
Corporations and governments commonly issue debentures to raise capital.
[ Do you control your finances or are your finances controlling you? Register to attend our FREE online real estate class and find out how real estate investing can put you on the path toward financial independence. ]
Features of Debentures
To understand how they work, you need to know about four core components:
Convertible vs. Nonconvertible
Debenture Credit Ratings
Since debentures are riskier than other types of bonds, they’re issued mainly by corporations with strong creditworthiness or a good financial reputation. You wouldn’t want to invest in a company that’s failing, would you? Especially if your investment isn’t secured.
Credit-rating agencies will assign letter grades to a corporation. A “AAA” rating is the highest rating, while C and D are the lowest. You should only invest in debentures from companies that receive a BB rating or higher. Anything below BB is considered a “junk bond.”
You’ll get paid interest when you invest, just like with other bonds. The interest rate for a debenture is called a “coupon rate.”
Your coupon rate depends on the company’s credit rating. If the issuing company has a strong credit rating, the interest will be lower. If it has a poor credit rating, the interest will be higher.
There are two types of interest rates: a fixed rate and a floating rate. A fixed interest rate never changes and remains the same throughout the length of the loan term.
A floating rate can change. Floating rates are usually tied to some kind of benchmark, like a 10-year U.S. Treasury bond. The floating rate will change as the benchmark changes, so if the benchmark increases by 1%, so will the floating rate on the debenture.
Debenture Maturity Date
Debentures have a predetermined maturity date, just like regular bonds. The maturity date is when a company/government must pay back the debenture in full.
There are two primary ways that they can mature. Most often, a company will pay a lump sum on the maturity date. For example, if an investor paid $5,000 on a 10-year debenture, the company would pay the investor $5,000 on the maturity date.
Sometimes, the company may choose to pay an annual repayment to the investor, with the final payment due on the maturity date. For example, if an investor paid $5,000 on a 10-year loan, the company would pay the investor $500 per year, with the final $500 due to be paid on the maturity date. This type of repayment is called a “debenture redemption service.”
Convertible vs. Nonconvertible Debentures
A company may allow an investor to convert their debenture into company shares. This is called a “convertible debenture.”
There are different types of convertible debentures:
You may have the option to convert your debt at any point during the repayment period
You may be forced to convert your debt when the debenture matures
You may be able to convert just a portion of your debt into shares—known as a “partial debenture”
Convertibles have risks for both the company and investors. When investors turn their debt into shares, it can dilute the company ownership, which may be harmful to the company when unprepared for.
For investors, there’s risk that comes with acquiring stock. Generally, stock investing is riskier than bond investing. Suppose the company is doing well financially and is capable of paying back the debenture. In that case, it might be safer and more profitable for the investor to opt for the bond repayment and bond interest. There’s always a chance that the company could encounter financial trouble in the future, and the value of the company shares could fall. [Stock research is important for anyone thinking about investing in debentures.]
Any debenture that doesn’t allow you to convert your debt into shares is called a “nonconvertible debenture.” Nearly all government-issued debentures are nonconvertible. After all, you can’t simply buy shares in a government.
Benefits of Debentures
Debentures have several benefits for both investors and companies/governments.
Benefits for investors include:
Good Coupon Rates: Debentures issued by companies with medium-to-poor credit ratings will come with higher interest rates. Of course, that means greater risk for the investor. But many investors see this as an attractive high-risk investment option for their portfolio. There’s also a possibility that a floating rate may increase after the start of the loan, which would increase the investor’s ROE.
Convertible: Some investors are drawn to convertibles, especially those in which the investor may convert at any point during the loan term. Savvy investors keep a close eye on the market—if there’s growing demand for the company’s stock, the investor will convert to shares and start selling.
Less Risk on Some Debentures: There’s a common misconception that debentures are always riskier than bonds because they’re unsecured. But in actuality, they are no more risky than bonds. Debentures that are issued by companies with strong credit ratings are often considered Stock research“>low-risk investments. Investors must pay close attention to the credit rating of the debenture and the credit profile of the issuing company.
Priority Over Stockholders: Companies always make payments to debenture holders before they make payments to stockholders. And if a company does go “bottom-up,” the debenture holders will be the first to get paid as the company reorganizes itself during bankruptcy. That’s why they are generally less risky than individual stocks.
Debentures also have benefits for corporations:
Lower Rates: Companies/governments with strong credit profiles will enjoy lower interest rates than standard bonds. They’re less taxing on the monthly or annual budget.
Changing Rates: If a company issues debentures with a floating rate, there’s a chance that the floating rate may decrease. The company would pay less money in interest than at the start of the loan term.
Longer Terms: Debentures are long-term loans that will be paid off over 10 years or more. Many standard bonds are paid off in 3 to 5 years, which doesn’t make them optimal for financing large projects that will take many years to generate returns. Debentures are much better suited for long-term financing due to their low rates.
Risks of Debentures
Like any kind of investment, debentures come with risk.
The risks for investors include:
Interest Risks: If you invest in a fixed-rate debenture, you could be in a bad position if the market has rising interest rates. For example, if your interest rate was 2%, but the market rates increase to 4% after a few years, you’d be missing out on a lot of money.
Inflation Risk: You could also be at a disadvantage if the interest rate does not keep up with the rate of inflation. For example, you’d suffer a net loss if your interest rate is 2%, but prices increase by 3% after a few years. Since debentures are long-term loans, inflation risk is greater than in investments with shorter terms.
Defaulting: Since debentures are not backed by collateral, you’re at greater risk if the company/government defaults on the debt. With a secured bond, the company would be able to sell assets to pay back the outstanding debt that’s owed to you. But with debentures, you may not get back your entire investment. In a best-case scenario, the company would settle its debt through bankruptcy reorganization—but that’s not always possible.
The risks for companies/governments include:
Diluted Ownership: For companies issuing convertibles, the biggest risk is having an unexpected dilution of company ownership. Ownership stake could fall significantly if many debenture holders acquire shares, which could lead to financial or administrative strife within some corporations. But most companies will issue nonconvertibles if they’re concerned about this.
Defaulting: Debentures are long-term loans that are generally used to finance projects that will take several years to generate sufficient returns. There’s always a risk that the project may fail to produce enough revenue to pay off the outstanding debt, plus interest.
What is a Bond?
A debenture is a type of bond. But what is a bond, exactly?
Bonds are a type of loan that’s issued to raise capital. Most often, they’re issued by corporations or governments.
The investor loans the corporation/government a predetermined amount of money, which the issuer pays back over time, with interest.
Every bond carries a credit rating that tells the investor how likely it is the bond will be repaid in full. If a bond has a poor credit rating, it usually means the issuer is in a poor financial situation and may not be able to generate enough revenue to pay back the investor.
But bonds are considered a relatively safe investment—many of them are issued by companies/governments with outstanding credit profiles. You can add bonds to your investment portfolio so you can balance your high-risk investments with income that’s slow and steady.
The caveat is that bonds don’t generate very high returns. Usually, the lower the risk, the lower the return.
Debentures vs. Traditional Bonds
What makes a debenture different from a traditional bond?
It can be difficult to differentiate between the two. In the U.K., a “debenture” actually refers to a bond that’s secured by company assets. In other countries, “bond” and “debenture” are interchangeable terms.
In the U.S., bonds and debentures only have two significant differences: purpose and collateral.
We’ve already discussed how bonds are backed by collateral, while debentures are not. So let’s discuss the purposes for which each of them is issued.
Bonds are commonly issued by governments—usually state and local governments. Most government bonds are long-term bonds that have maturities of 10 years or more. They’re often used to finance specific projects, like infrastructure expansion or building out new departments.
Corporations also issue bonds to raise capital. Corporate bonds fall into three categories: short-term bonds, medium-term bonds, and long-term bonds. Long-term corporate bonds are not always beneficial to corporations because their interest rates are highly volatile and they also force corporations to collateralize their assets—over the course of 10 years, a company may want to sell those assets, so that can be a hindrance.
Debentures are a good way for corporations to issue long-term bonds with favorable interest rates and without collateralizing assets. Like long-term government bonds, corporate bonds are used to finance specific company projects, like global or product expansions.
Other than that, debentures and bonds are mostly similar. They share a similar level of risk: issuers with a strong credit profile are generally low-risk, while issuers with a poor credit profile are higher risk. Both of them yield relatively little returns, but they can be a good conservative addition to your investment portfolio.
How to Invest in Debentures
Debentures are a great way to diversify your investment portfolio. You can invest in them from nearly any kind of brokerage. If you’re new to investing and haven’t yet opened an account at a brokerage, you might consider using an online broker. This is one of the easiest and most affordable ways to shop for debentures.
Once you open an account at a brokerage of choice, you can start comparing the different types they offer. You’ll probably find these under the broker’s selection of “fixed income” securities.
When you’re browsing their selection of debentures, thoroughly review each one and compare their:
Don’t forget to think hard about your own financial goals. Do you want a high-risk investment or low-risk investment? Do you want a convertible debenture? Do you want a lump-sum repayment, or do you want payments annually? Answering these questions will help you find the right debenture for you.
A bond is a loan that’s issued by a company or government to finance a project, and it’s paid back to investors with interest. A debenture is a type of bond that’s not backed by collateral, as traditional bonds are. Because they’re not secured, debentures are sometimes riskier because you might not be able to get all your money back if the loan defaults. But not all debentures are created equal. When they’re issued by a company with a strong credit profile, debentures are a safe and low-risk investment option, and are no more risky than traditional bonds.
Do you want to be able to retire financially comfortable?
Our new online real estate class can help you learn how to invest in rental properties that can help increase your monthly cash flow. Expert investor Than Merrill shares the core real estate investment principles that work best in today's real estate market.
Register for our FREE 1-Day Real Estate Webinar and get started learning how to invest in today's real estate market!