Definition
A debenture is a type of debt instrument that is not backed by physical assets or collateral. Instead, it is backed only by the general creditworthiness and reputation of the issuing entity. They often come with a fixed interest rate and specified repayment period, and are usually issued by corporations and governments to raise capital.
Key Takeaways
- Debentures are a debt instrument used by companies to raise long-term capital. They are essentially a loan to the company, with the promise that the company will repay the principal amount at a future date.
- These instruments come with a fixed interest rate, often referred to as a coupon rate, which is the return investors can expect for lending their money to the company. The interest is usually paid annually or semi annually.
- Unlike secured loans, debentures are often unsecured, meaning they are not backed by any collateral. If the company fails to pay back, the investor has no claim to any specific asset of the company. However, they are ahead of equity shareholders in the hierarchy of payout structure in case of liquidation.
Importance
Debentures are an important financial instrument used by large companies to borrow money at a fixed rate of interest.
They play a crucial role in raising long-term funds for businesses, thus contributing directly to capital expansion and growth.
Unlike traditional loans, debentures are unsecured, meaning there’s no collateral backing them; instead, they rely on the creditworthiness and reputation of the issuer.
Additionally, these instruments are attractive to investors as they often offer higher interest rates than savings accounts or other investment products.
Overall, the ability to issue debentures provides companies with greater financial flexibility, making them a vital component of corporate finance and investment portfolios.
Explanation
Debentures play an instrumental role in raising capital for large-scale projects or routine operations in a company, serving as long-term loans that corporates borrow from the public. When a company requires funding for expansion, diversification, or development projects, but doesn’t want to increase its equity capital (to avoid dilution of control), it may choose to issue debentures. These instruments provide a win-win situation for both the company and investors.
The company benefits from borrowed capital without the need to put up collateral, and in return, promises to pay periodic interests and return the principal amount at maturity. On the investor side, debentures serve as an appealing investment opportunity promising stable and fixed returns at specified intervals, typically semi-annually or annually. They are particularly attractive to conservative investors seeking less risky investments.
Debentures also give investors the flexibility to sell before maturity in the secondary market, making them more liquid investments. Furthermore, debentures can be converted into the equity shares of the company (convertible debentures), providing another potential gain for investors. It’s important to remember, however, that while debentures offer the allurement of fixed income, they also present a potential downside risk in case of the company’s insolvency or bankruptcy, as debenture holders are classified as unsecured creditors in such scenarios.
Examples of Debentures
**General Motors (GM) Debentures**: In 2008, to deal with the financial crisis, General Motors issued debentures to raise funds. These debentures were convertible, they could be converted into equity shares after a certain period.
**Shell Petroleum Debentures**: Oil and Gas giant, Shell Petroleum, issued debentures in 2019 worth $
5 billion at an interest rate of
2% per annum. The funds raised were used for business diversification and the payment of debts.
**Tesla Debentures**: In 2014, the electric car manufacturer, Tesla, issued convertible debentures to raise $2 billion for the expansion of their Gigafactory in Nevada. The debentures attracted investors with fixed returns and the potential to convert the debenture into shares if Tesla’s stock prices rise in the future.
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Frequently Asked Questions about Debentures
What is a Debenture?
A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer, usually a corporation.
What are the types of Debentures?
Debentures can primarily be classified into two types: Convertible Debentures and Non-Convertible Debentures. Convertible debentures are the ones that can be converted into equity shares of the issuing company after a specified period. Non-Convertible Debentures are those which cannot be converted into equity shares of the liable company.
How do Debentures work?
Debentures work as a long-term financial instrument which a company can use to borrow funds. Debenture holders receive a fixed rate of interest on their investment, irrespective of the level of profits made by the company.
What is the risk associated with Debentures?
The biggest risk that comes with investing in debentures is the risk of default, where the issuer is unable to make interest or principal payments. As unsecured debts, debentures are often riskier than secured debt instruments, but they also often offer higher yields.
What is the relationship between Debentures and interest rates?
The price of a Debenture on the market can be sensitive to changes in interest rates. When interest rates increase, the price of a Debenture on the market typically decreases because the fixed interest rate of the Debenture becomes less attractive in comparison to other investments.
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Related Entrepreneurship Terms
- Bond
- Unsecured Loan
- Fixed Interest Rate
- Maturity Date
- Creditors
Sources for More Information
- Investopedia: Is an American financial website that provides investment dictionaries, advice, reviews, ratings, and comparisons of various financial products such as brokerage accounts.
- Reuters Finance: Reuters brings you the latest news on finance from around the world, including updates on global markets, economics, and personal finance.
- Bloomberg Finance: Bloomberg L.P. gives financial software tools such as an analytics and equity trading platform, data services, and news to financial companies and organizations.
- Coursera: Provides universal access to the world’s best education, partnering with top universities and organizations to offer courses online, including finance and investment.
