Definition — what a debenture is
A debenture is a form of debt instrument (a type of bond) that is not secured by specific collateral. Instead of a pledge of assets, a debenture depends on the issuer’s general creditworthiness and legal promise to repay. Corporations and governments can issue debentures to raise long‑term funds; investors receive periodic interest payments and eventual repayment according to the terms in a written contract.
Core terms, briefly defined
– Coupon: the periodic interest payment to the holder.
– Indenture: the legal contract that sets the debenture’s terms (maturity, coupon timing, covenants, etc.).
– Trustee: an independent party named in the indenture to represent investor interests.
– Maturity date: when the issuer must repay principal.
– Credit rating: a letter grade from a ratings agency (e.g., S&P) signaling default risk.
– Registered vs bearer: registered debentures record ownership with the issuer; bearer debentures pay interest to whoever physically holds them.
– Redeemable vs irredeemable: redeemable debentures must be repaid by a specified date; irredeemable (perpetual) have no fixed repayment date.
– Convertible vs nonconvertible: convertible debentures can be exchanged for a fixed number of shares of the issuer; nonconvertible cannot.
Types and how they differ
– Registered debenture: ownership tracked; issuer pays interest to the recorded holder.
– Bearer debenture: unregistered; whoever holds the certificate receives interest.
– Redeemable (term) debenture: specifies precise repayment terms and date(s).
– Irredeemable (perpetual) debenture: pays interest indefinitely with no contractual maturity.
– Convertible debenture: contains an option to convert the debt into equity at a pre‑set ratio and time. Because of the conversion option, these usually carry a lower coupon.
– Nonconvertible debenture: plain debt that pays a higher coupon to compensate for no conversion feature.
Key features investors should check
– Coupon rate (fixed or floating) and payment frequency.
– Maturity date and repayment method (single redemption vs amortizing).
– Whether the debenture is secured or unsecured (debentures are unsecured by definition).
– Convertibility and conversion terms (if applicable).
– Registration type (registered vs bearer) and transferability.
– Trustee and key covenants in the indenture.
– Issuer credit rating and the ratings’ implications for default risk.
– Call or put provisions (issuer’s right to redeem early, investor’s right to demand early repayment, if any).
Advantages and disadvantages (summary)
Advantages for issuers:
– Typically lower cost than some secured loans; long maturities are available.
Advantages for investors:
– Regular income and priority over equity in repayment (but behind secured creditors).
Disadvantages:
– No collateral backing means higher default risk than secured debt.
– Coupons may be lower for convertibles, and bearer issues pose theft/fraud risk.
– Perpetual debentures may provide no principal return date.
Risks to investors
– Credit/default risk: issuer may fail to make interest or principal payments.
– Interest‑rate risk: market value falls if prevailing rates rise.
– Liquidity risk: some debentures trade thinly and can be hard to sell at fair prices.
– Reinvestment risk (if coupons paid when rates are lower) and, for convertible holders, equity dilution risk upon conversion.
Is a debenture an asset or a liability?
– For the issuer (company/government): a debenture is a liability — an obligation to pay interest and possibly repay principal.
– For the investor (debenture holder): it is an asset that generates interest income and can be sold.
How a debenture is structured (step‑by‑step)
1. Issuer and legal counsel prepare a trust indenture that defines terms and covenants.
2. A trustee is appointed to protect investor interests.
3. Coupon rate is set (fixed or floating, possibly tied to a benchmark like a 10‑year Treasury yield).
4. Credit‑rating agencies may assess the issuer and assign ratings that influence investor demand and required coupon.
5. The issue is sold to investors; periodic interest payments and any eventual redemption are administered per the indenture.
Small worked example (coupon and current yield)
Suppose Company X issues a debenture with:
– Face (par) value: $1,000
– Annual coupon rate: 6% (paid annually)
– Maturity: 5 years
Annual coupon payment = 6% × $1,000 = $60.
If an investor buys the debenture in the market for $950, the current yield = annual coupon / price = $60 / $950 ≈ 6.32%. This current yield measures annual income relative to cost, not total expected return (it ignores capital gain/loss to maturity and time value).
Short checklist before buying a debenture
– Confirm issuer identity and business fundamentals.
– Read the indenture for covenants, repayment schedule, and trustee duties.
– Check credit ratings and recent rating actions.
– Note coupon type (fixed vs floating) and payment frequency.
– Verify convertibility, call/put features, and registration status.
– Assess market liquidity and transaction costs.
– Compare current yield to alternative fixed‑income options with similar risk.
How debentures compare to secured bonds
Both are debt instruments. The main difference: secured bonds have specific collateral backing repayment; debentures do not. Without collateral, debentures generally require a higher coupon to compensate investors for greater risk.
Bottom line
A debenture is an unsecured long‑term debt instrument backed by the issuer
’s creditworthiness rather than specific collateral. That means investors rely primarily on the issuer’s legal promise to pay principal and interest and on any contractual covenants in the bond documentation.
Common variations and special features
– Subordination: A subordinated debenture ranks below other unsecured or secured creditors in bankruptcy. Subordinated instruments carry higher risk and therefore typically higher yields.
– Convertible debentures: These can be converted into equity (shares) at a preset conversion ratio or price. Conversion adds equity upside but usually lowers the coupon versus a plain debenture.
– Callable and putable features: A callable debenture lets the issuer redeem the debt early (usually at a premium); a putable debenture lets the holder require early redemption. Calls benefit issuers when rates fall; puts protect investors when rates rise or credit deteriorates.
– Floating vs fixed coupons: Floating-rate debentures have interest tied to a reference rate (e.g., LIBOR or SOFR) plus a spread; fixed-rate debentures pay a set coupon. Floating-rate instruments reduce interest-rate risk but may carry different credit sensitivity.
– Registered vs bearer form: Registered debentures name the owner on the issuer’s records; bearer debentures pay whoever physically holds the certificate. Most modern issues are registered for anti‑fraud and tax reasons.
How to find issuer and contract information (practical steps)
1. Get the official documents: search the issuer’s filings or the prospectus/indenture on the SEC EDGAR system (for U.S. issuers).
2. Read the indenture summary: identify priority of claims, covenants, call/put terms, and events of default.
3. Check rating reports from major agencies (S&P, Moody’s, Fitch) for key credit drivers and outlooks.
4. Look up trade and price data: use TRACE (U.S. corporate bonds), broker quotes, or market data terminals for liquidity and recent transaction prices.
5. Ask the trustee: the bond trustee enforces covenants—ask for any recent covenant waivers or amendments.
Pricing and valuation — formulas and worked example
Basic price formula for a plain vanilla fixed‑coupon debenture:
Price = sum from t=1 to N of [C / (1 + y)^t] + [F / (1 + y)^N]
Where:
– C = coupon payment per period
– F = face (par) value repayable at maturity
– y = periodic market yield (if payments are semiannual, y = YTM/2)
– N = total number of periods
Worked numeric example (step‑by‑step)
Assume a 5‑year debenture, face value F = $1,000, annual coupon 6% paid semiannually, market YTM = 8% (annual).
1. Periodic coupon C = $1,000 * 6% / 2 = $30.
2. Periodic market yield y = 8% / 2 = 4% = 0.04.
3. Total periods N = 5 * 2 = 10.
4. Price = sum_{t=1}^{10} 30/(1+0.04)^t + 1000/(1+0.04)^{10}.
Compute the annuity part:
– Present value of coupons = 30 * [1 – (1+0.04)^{-10}] / 0.04 ≈ 30 * 8.1109 ≈ $243.33.
– Present value of principal = 1000 / (1.04)^{10} ≈ 1000 / 1.4802 ≈ $675.56.
5. Total price ≈ $243.33 + $675.56 = $918.89.
Interpretation: the debenture trades below par because the coupon (6%) is below the market yield (8%).
Interest‑rate and credit risk interaction
– Duration: longer maturities and lower coupons increase interest‑rate sensitivity (duration). A debenture with no collateral compounds credit sensitivity because recovery in default is generally lower.
– Credit deterioration and spreads: if an issuer’s credit worsens, its debenture’s yield spread over government or risk‑free rates widens. Because debentures are unsecured, spread movement can be larger than for secured debt.
Taxation and recovery in default (general rules)
– Interest on corporate debentures is generally taxed as ordinary income for U.S. investors; specific treatment depends on jurisdiction and investor status.
– Recovery rates in bankruptcy for unsecured creditors vary widely; historical recoveries for unsecured corporate debt are materially below secured creditors’ recoveries.