What Is a Debenture? Key Characteristics and Types

A debenture is a financial instrument representing a type of debt companies issue to raise capital. It acts as a formal acknowledgment of a loan, where the issuer promises to repay the borrowed amount along with interest to the debenture holder. These instruments are typically used for medium to long-term financing and allow businesses to secure funds without diluting ownership or pledging specific assets as collateral. Debentures are a common method for corporations and governments to obtain funds from the public.

Key Characteristics

A primary characteristic of debentures is their unsecured nature; they are not backed by specific physical assets or collateral. Their repayment relies on the issuer’s creditworthiness and reputation. Debenture holders are considered creditors of the issuing entity, not owners, and therefore do not possess voting rights.

Debentures feature a fixed maturity date, when the principal amount must be repaid to the debenture holders. Throughout their term, debentures provide periodic interest payments to investors, which can be at a fixed or variable rate. This interest is considered a charge against profit, paid before dividends to shareholders and can be a tax-deductible expense for the issuer. The terms of a debenture, including the interest rate, repayment schedule, and maturity date, are detailed in a document called an indenture.

Types of Debentures

Debentures can be classified in various ways, reflecting different terms and conditions set by the issuer. Registered debentures record the ownership details with the issuing company, and their transfer requires formal procedures. In contrast, bearer debentures are freely transferable, with interest payments made to whoever physically holds the certificate.

Convertible debentures offer the holder the option to convert the debt into equity shares of the issuing company after a specified period. This feature can provide both interest income and potential for capital appreciation through equity ownership. Non-convertible debentures cannot be converted into shares and offer higher interest rates to compensate for the lack of conversion privilege.

While debentures are unsecured, some classifications relate to their priority in repayment. Secured debentures may be backed by a general charge over the company’s assets, which can be either fixed or floating. A fixed charge is on specific, identifiable assets, while a floating charge is over a pool of assets that can change, such as inventory or accounts receivable. Unsecured debentures rely solely on the company’s financial standing without any asset backing.

Debentures also differ in their maturity terms. Redeemable debentures have a fixed maturity date, at which point the principal amount is repaid to the investors. Irredeemable, or perpetual, debentures do not have a fixed maturity date and pay interest indefinitely, with the principal only repaid upon the company’s liquidation.

Distinguishing from Other Debt Instruments

Debentures are compared with other forms of debt, such as bonds and loans, but possess distinct characteristics. A key difference between a debenture and a bond lies in their security. While bonds are secured by specific assets or collateral, debentures are unsecured, relying on the issuer’s overall creditworthiness.

If a bond is unsecured, it can be referred to as a debenture. This means that while all debentures are a type of bond, not all bonds are debentures. Debentures are issued to a broad base of investors, making them marketable securities.

In contrast, a traditional loan involves a direct agreement between a borrower and a single lender, such as a bank. Loans can be secured by collateral or unsecured. Unlike a single loan, debentures are issued as certificates to many investors to raise capital, offering a standardized way for companies to access funds from the public market. This broad issuance and tradability differentiate them from private loan agreements.