How Debentures Work
Understanding the Differences and Similarities
It’s common for companies to float bonds to help fund operations and invest in growth. Bonds allow individual investors to essentially loan money to a company, and the company will pay the investor back—with interest—after a pre-determined time.
Bonds are the most common debt instrument that companies use, but there is a specific type of instrument, known as a debenture, which is a common type of bond. Debentures work similarly to traditional bonds, except they are not secured by collateral or any assets. Instead, people buy debenture bonds on the assumption that the borrower is trustworthy enough to pay it back. In other words, the lender just assumes the borrower is “good for it.”
The terms "bonds" and "debentures" are often used interchangeably—and sometimes incorrectly. While a debenture is a type of bond, not all bonds are debentures. However, like traditional bonds and other investments, the average investor can buy debentures through a brokerage firm.
Secured vs. Unsecured Debt
To understand what a debenture is, it’s helpful to review the various ways that companies can borrow money. A “secured” debt is a type of bond that is backed by something. A mortgage bond, for example, is backed by land or a building. Companies might also float equipment bonds that are backed by the machinery it owns.
Some debt, however, is considered “unsecured.” In this case, lenders are willing to purchase bonds simply because they trust the borrower. Large companies with lots of money and good cash flow—and the good credit ratings that come with that—can usually get away with offering unsecured debt. A debenture is just another term for unsecured debt.
Large companies with good credit ratings will often issue debentures rather than asset-backed bonds because they would prefer not to tie up their assets if they don’t have to. However, there are some instances in which a company will issue debentures because all of its other assets are serving as collateral for other borrowings. In this case, the debentures may be a larger risk for the investor.
U.S. Treasury bonds are perhaps the most common form of debentures. Among investors, there is very little fear that the U.S. government will ever default on its loans. Thus, the government can issue debentures, and investors will purchase them simply because they are confident in the government’s ability to pay them back.
Convertible and Non-Convertible Debentures
In some cases, a company will allow an investor to convert their debenture into shares of the company. It makes them an attractive option for investors because they can gain equity in the company.
There are different kinds of convertible debentures. Some simply give the investor the option to turn the debt into equity at some point. This is common when an investor purchases the debt of a new company and isn’t sure if they will want shares at the time the debenture matures.
In other cases, the company forces the conversion of debenture into company shares. There are also partially convertible debentures, in which some portion of the debenture is turned into equity while the rest is redeemed in a typical fashion.
With convertible debentures, there is some risk on both sides. For the company, there is a risk in allowing the debenture to be turned into shares in the company because it can dilute the company ownership. For the investor, there is the risk that comes with loaning unsecured debt—they could end up with nothing if the company goes under.
If a Company Goes Belly-Up
Every once in a while, a company will go out of business, and its assets will be liquidated. In this case, there is usually an order to which lenders get paid back. Those who purchased secured debt will be taken care of first, followed by those who bought debentures. Shareholders are usually last in line.
Thus, there is some risk in purchasing debentures, especially when compared to secured debt, which is why debentures are much more common among companies with high credit ratings. Without high credit ratings, it's unlikely that anyone would buy the debentures.
Debentures Outside the United States
In other parts of the world, the term “debenture” is used differently. In Great Britain, a debenture is simply a term for long-term security with a fixed interest rate, backed by a company’s assets. In other words, debentures are secure debt in the UK.
The term “debenture” has also been used for a kind of debt in the sporting world. Teams in England, in particular, have issued debentures to help fund construction, and the holders receive tickets to games or part ownership of the team.