Debentures vs. Notes: The Key Differences

Companies require capital to operate and expand. While funds can come from profits or issuing stock, a significant portion is often raised by borrowing. Businesses accomplish this by issuing debt instruments, which are formal IOUs sold to investors, representing a loan the company promises to repay with interest.

This financing method allows a corporation to secure funds without diluting the ownership of its existing shareholders. The specific terms of these loans, such as the interest rate and repayment schedule, are detailed in a formal agreement.

Defining Debentures

In the United States, a debenture is a long-term debt instrument that is not secured by any specific physical asset or collateral. It is supported solely by the general creditworthiness and reputation of the issuing company. The terms of the debenture are outlined in a document called an indenture, which is a legal contract between the issuer and investors.

Due to their unsecured nature, debentures carry a higher level of risk for investors. Consequently, these instruments are almost exclusively issued by large, well-established corporations with strong balance sheets and a history of profitability. If the issuing company were to face bankruptcy, debenture holders would not have a claim on any particular asset.

Debentures are long-term obligations, with maturity dates of 10 years or more. This structure makes them suitable for financing major corporate projects. Some debentures also include a convertibility feature, giving the holder the option to convert the debt into a predetermined number of the company’s stock shares.

Defining Notes

A corporate note is another form of debt instrument that companies use to raise capital. Unlike debentures in the U.S., which are uniformly unsecured, notes can be structured as either secured or unsecured debt. This adaptability allows them to serve a broader range of financing needs for a wider variety of companies.

A secured note is backed by specific collateral, which can include assets like real estate or machinery. This collateral is pledged to the noteholders, providing them with a direct claim on those assets in the event of a default. If the company fails to make its payments, the holders of the secured note can take possession of and sell the pledged assets to recoup their investment.

The maturity period for notes is also highly variable. Notes can be issued with short-term maturities of less than a year, medium-term maturities from two to ten years, or long-term maturities. This range allows companies to match the term of the financing to a specific need.

Primary Distinguishing Factors

The difference between these two debt instruments lies in the presence or absence of collateral. A debenture is, by definition in the United States, an unsecured form of debt. A note, conversely, can be either secured by specific corporate assets or unsecured.

This distinction in security directly impacts the order of repayment if a company enters bankruptcy. Holders of secured notes have a higher priority claim and are paid from the proceeds of the specific collateral they hold before other creditors. Debenture holders, being unsecured creditors, are paid only after all secured debts have been satisfied.

Another point of contrast is the length of the loan. Debentures are almost always issued for long-term financing, with maturities that frequently extend beyond a decade. Notes, however, are used for a much wider spectrum of time horizons, demonstrating a versatility not found in debentures.

The profile of the issuing entity also differs. Because debentures rely on the issuer’s reputation, they are the domain of large corporations with pristine credit ratings. The ability to secure a note with assets allows smaller or less-established companies to access debt markets.