What is a Debenture?

Ryan Patrick

• 10 min read
What is a Debenture?

A debenture is an unsecured debt instrument or bond, meaning no collateral is needed for the funding. Debentures raise funds from the public or lending institutions, and the borrower promises to pay back the loan, including periodic interest rates, as agreed.

Since a debenture has no collateral, an agreement displaying the terms between the lending body and borrower is drawn.

A debenture holds the borrower’s assets as the only security, granting them the power to collect the debt if the borrower doesn't pay up. Traditional borrowers use debentures like banks that fund corporations or the government.

Any corporation that seeks funding through debentures must be registered at Companies House. Plus, debentures can only be accessible to limited companies or limited liability partnerships. Typical partnerships or sole proprietorships don't qualify for debentures.

If the term debentures is a new vocabulary, spare a few minutes to read this insightful post. Without much ado, let's find out what a denture is, the types of debentures, how they work, and who can access them.

Basic Understanding of Debentures

Like most bonds, debentures pay periodic interest payments known as coupon payments, which are recorded in an indenture.

An indenture is a legally binding contract between the issuers and holders of a bond. The contract displays the specific features of a debt like:

  • Maturity date
  • The timing of interest (coupon payments)
  • The method of interest calculation

So, who can issue debentures? Corporations and governments can issue debentures.

  • Governments issue long-term bonds with a maturity period longer than ten years. Since the government backs them, these long-term bonds are considered low-risk investments.
  • Corporations can also issue debentures as long-term loans, but they're unsecured. Instead, these debentures only have the backing of a company's financial viability and creditworthiness. These loan vehicles pay an interest rate and can be redeemable or repayable on a fixed date.

The scheduled debt payments are remitted before the stock dividends are paid to shareholders. Since debentures have low-interest rates and longer repayment dates, they're favourable for companies compared to other loans or debt vehicles.

The Main Types of Debentures

Debentures are in two categories: floating and fixed-charge dentures.

A debenture can be one of two different types: floating charge debentures and fixed charge debentures.

1. Floating Charge Debenture

A floating charge means the assets under the charge may change over time. HOW? The borrower can sell or move the assets within daily business activities. These assets can include:

  • Stock
  • Raw materials
  • Cash Debtors Cars
  • Fixtures
  • Intellectual property
  • Fittings

If the borrower defaults and pays the debt as agreed, the floating charge is inclined to 'crystallise' and become fixed.

After crystallisation, the borrower can't deal, move, or change the assets without the lender nodding. In extreme cases where a company faces insolvency or liquidation, a floating charge grants the lender priority over unsecured creditors to recover their funds.

2. Fixed Charge Debenture

Under a fixed charge, the lender owns the borrower's assets whenever they DEFAULT payment. The revenue of any subsequent sale goes towards repayment of the remaining debt.

All assets covered under a fixed charge are under the lender's control, meaning the borrower CAN only SELL them after seeking permission.

If these assets are sold, the earnings go to the lender or are used to buy a new asset, and the lender can issue a new fixed charge. Fixed charges are popularly issued over properties like:

  • Fixtures
  • Trade fixtures
  • Motor vehicles
  • Fixed plant
  • Machinery
  • Freehold or leasehold of a property

In the event of receivership or liquidation, fixed charge holders come first in the order of repayment.

3. Multiple Debentures

Are you considering registering multiple debentures?

A company can register multiple debentures simultaneously, especially for more giant corporations. These corporations with diverse financing needs can issue several debentures to meet specific goals. Each series of debentures serves unique terms, interest rates, and maturity dates, which allows the company to channel its financing to different projects or initiatives.

Multiple debentures series are beneficial to both the company and investors. For a company, there's flexibility in managing its debt portfolio. It also allows a company to access various debt market segments.

Conversely, investors can choose from various debentures available depending on their risk tolerance and investment goals. After deciding to register multiple debentures, each series will have its indenture stating the distinct terms and conditions of the specific issuance.

The Features of a Debenture

When issuing a debenture, an indenture is drafted for trust purposes among the issuing body and the trustee managing investor interests.

1. Interest Rate

Debentures operate at a fixed interest rate, which a company pays the debenture holder or investor. The coupon rate can be a fixed or floating charge. A floating rate can be tied to a standard 10-year Treasury bond and will change if the benchmark changes.

2. Credit Rating

A company's credit rating and the debenture's credit rating play a significant role in determining the interest rate investors will receive. Credit rating bodies gauge the creditworthiness of corporations and governments to provide investors with an overview of what to expect when investing in debt.

3. Maturity Date

The maturity date is an essential feature that dictates when a company must pay debenture holders. There are multiple ways a company can repay the debenture:

  • Redemption from the capital, where the issuer pays a lump sum once the debt matures
  • Redemption reverse is the alternative mode of payment where the company remits and pays specific amounts annually until the repayment is made in full by the maturity date.

4. No Ownership Rights

Debenture holders are creditors of the issuer, not the owners, meaning they have no voting rights in the issuing company. The relationship between the two is that of lender and borrower.

5. Secured or Unsecured

Secured debentures have the backing of the issuer's assets, meaning they serve as collateral. The assets provide security on the principal amount and interest payment, meaning they're risk-free investments.

No collateral or security is needed for unsecured debentures, and they are riskier investments with higher interest rates to cover the increased risk.

6. Transferability

Debentures can be transferred through selling, trading, or transfer to other parties in the secondary market. The feature boosts liquidity and lets investors exit the investment when necessary.

Different Types Of Debentures

Debentures come in several forms, and each has varying characteristics. Each debenture has varying terms and conditions like conversion rights, redemption provisions, and interest rates. The different forms of dentures include:

  • Convertible debentures - offer the holder an opportunity to convert the debenture into equity shares after a specified time. Conversion allows the company to benefit from capital appreciation when stock prices increase. As a result, creditors become shareholders.
  • Non-convertible debentures (NCDs) aren't convertible into equity shares and remain as fixed-income securities throughout the tenure. They give investors a stable income from a fixed interest rate until the debt matures.
  • Redeemable debentures come with a specified maturity date, and the issuer can repurchase them from the holder upon maturity at face value. Once it matures, investors receive the periodic interest and the principal amount, making it clear which investment will be paid.
  • Irredeemable debentures (perpetual debenture) - Irredeemable debentures have no fixed maturity date; they continue indefinitely, and the issuer can't repurchase them. The principal amount remains invested, has no specified date for maturity, and investors receive periodic interest, offering an infinitive income source.
  • Registered debenture - The issuer maintains a list of debenture holders. They're linked to specific investors, and the holder has no register of the holder's details (names and contact details).
  • Unregistered debentures - Unlike registered debentures, unregistered debentures have no list of individual holders and are deemed bearer holders. They're easily transferable without ownership, making them convenient for trading in the secondary market.

The Role of Debentures when a Company Insolvency

When a company defaults on a loan, an administrator can be appointed by the debenture holder to manage the company. Non-paying companies perceive the appointment of an administrator as a THREAT to force them to repay the debt.

With the appointment of an administrator or liquidator, assets covered by the debenture are transferred to the lender. Mostly, the lender arranges to sell the assets at a fee.

In case the situation gets to insolvency, the money available is repaid to creditors in the following order or priority:

  1. Secured creditors - Those with a legal mortgage, fixed or legal charge are settled first.
  2. Preferential creditors - Employees owed arrears in wages and holiday pay
  3. After paying priority creditors fully, a 'prescribed part' of the amount is dedicated to unsecured creditors.
  4. The remaining amount (after setting aside the prescribed part) pays floating charge holders.
  5. Finally, all unsecured creditors are settled. They include:
  • PAYE
  • VAT
  • NI
  • CIS tax
  • Corporation tax
  • Trade creditors
  • Expense creditors

The Pros of Debenture

Investing in debentures has several benefits:

  • It suits investors with a fixed income stream with minimal risk.
  • Debentures have no voting rights; hence, funding through debentures doesn't impact the management control equity shareholders hold.
  • Debentures are unsecured, meaning the business doesn't use its income as collateral.
  • With stable sales and earnings, issuing debentures is an intelligent decision.
  • Unlike equity capital, debentures operate on tax deductibles, making them a cost-effective way to get funds.

The Cons of Debenture

Here are the disadvantages of debenture.

  • Companies have a limited borrowing capacity, with future ability to borrow only possible by issuance of debentures.
  • Repayment of redeemable debentures must be made on a designated date, even when a company is in financial distress.
  • Debentures lower the ability of an organisation to make money permanently, and when revenue varies, the risk is higher.

Debenture Risks to Investors

  1. Inflation risk - Debenture holders may be unable to pay debt interests or keep up with the inflation rate risk. For instance, if prices rise to 3% due to inflation, and the debenture coupon pay is at 2%, it may translate to an actual net loss to the holders.
  2. Interest rate risk - Debentures hold a fixed-rate debt even when market interests rise. As a result, investors may receive less money on their debt than from other market investments, paying more per the current market rate. Whenever this happens, the debenture holder earns less in comparison.
  3. Credit risk and default risk - Debenture security depends on the issuer's financial strength. So, if the company is experiencing financial difficulties due to internal or macroeconomic factors, the risk of default on the debenture is real to investors. However, it may be some consolation that a debenture holder is repaid before other stock shareholders after liquidation.

Market trends influence the attractiveness and price of debentures. During low-interest rate periods, debentures have a reduced borrowing cost, favouring companies. However, in high-interest times, the high service costs can hinder issuers.

As for investors, stable economic conditions make debentures more appealing for fixed returns and security than unstable stocks. During uncertain times, intensified default risks require careful evaluation of a company's creditworthiness. Both issuers and investors must pay attention to market shifts to ensure maximum benefits and alleviate debenture risks.

Comparing a Debenture and a Loan

A debenture and a loan are both borrowing vehicles, yet unique in various ways:

Debentures

  • Debt instruments issued by companies to make capital
  • Unsecured, meaning no collateral or physical assets are needed
  • Debenture holders receive interest and principal amount upon maturity
  • Companies issue debentures to investors who become creditors of the company
  • Long-term financing

Loans

  • A loan is an amount borrowed from a lender
  • The amount plus interest is payable within a specified period
  • Loans are either secured (requires collateral) or unsecured (no collateral needed)

Comparison Between Debentures and Shares

Debentures and shares are both financial instruments businesses use to raise capital. However, they're unique in various ways:

Nature

  • Companies use debentures to raise capital with a fixed claim on interest payment and principal repayment.
  • Shares are small portions that make a company and are owned through buying by shareholders. Shareholders have voting rights, and they receive company profits as dividends.

Ownership and Voting Rights

  • Debenture holders have no voting or ownership rights in a company because they're lenders who receive fixed interest payments.
  • Shares grant shareholders the right to vote because they own the company. They can also participate in decision-making, such as by electing company directors.

Return on Investment (ROI)

  • Debenture holders receive a predetermined interest rate until the principal amount matures for repayment.
  • Shares are only profitable to shareholders when the company is making profits to pay dividends. Capital appreciation is another way shareholders benefit from shares.

Risk and Reward

  • Debenture holders are exposed to lower risks than shareholders with a fixed claim on interests and the principal amount.
  • Shares are riskier since returns depend on the company's performance, as they may benefit from capital appreciation, but there's no return guarantee.

Comparing Debentures and Bonds

Debentures and bonds are debt instruments companies, and governments use to raise capital, but they have fundamental differences.

Definition

  • Debentures are unsecured long-term debt vehicles used by companies to raise funds. Interests are paid periodically until the principal amount matures for repayment.
  • Bonds are debt securities that can be secured or unsecured. Corporations, governments, or municipalities issue them with a promise to pay back the principal amount with periodic interest.

Issuer Type

  • Corporations mainly use debentures to raise capital in the private sector.
  • Bonds are issued by various issuers: corporations, governments, and municipalities.

Conversion Features

  • Debentures have no conversion features, so they can't be converted to equity stock.
  • Bonds: some bondholders can convert to equity shares under specific conditions.

Risk and Returns

  • Debentures are considered to be higher risk than bonds
  • Bonds vary in risk depending on factors like the issuer's credit rating.

Credit Rating

  • Debenture issuers are subject to credit rating, which impacts the interest rates they offer to appeal to investors.
  • Credit ratings also affect bonds, which influence interest rates and credit risk.

Frequently Asked Questions

Is there a difference between a debenture and a loan?

A loan and debenture are different: a loan must be paid back within a specified time and secured against something of the same value. Debentures don't need the security of something with equal value but something of significant value.

Are bonds and debentures different?

Bonds are debt vehicles by lending institutions, large corporations, and government bodies with the backing of collaterals and assets. Debentures are debt vehicles issued by private companies with no support of any collaterals or physical assets.

Are debentures better than bonds?

Although multiple factors influence the interest rates, debentures offer higher rates than bonds. Interest rates for the two financial debt instruments make a massive difference in determining the cash flow investors receive.

Conclusion

A debenture is a loan agreement only taken by limited companies or limited partnerships registered at Companies House. It's a form of business finance that can be in two categories: floating charge or fixed charge debenture, and it is not accessible to sole traders or standard partnerships.

Debentures are unsecured bonds issued by corporations and governments, making them riskier investments. Unlike secured bonds backed by collateral, unsecured bonds have no backup assets in case of a default in payment. They solely rely on the creditworthiness of the issuer.

Debentures are financial cornerstones offering companies and investors valuable financing and investment opportunities. Their path of debentures is mainly influenced by market trends, which can sometimes be favourable or unfavourable. Understanding the nuances of debentures is essential to help investors and companies make informed financial decisions. Do you have any questions about debenture? Kindly ask one of our Incorpuk experts here.