What Is a Debenture Bond? Definition & Types

A Debenture Bond Secured Debentures,
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A debenture bond is a type of bond that is issued by a corporation. It is not secured by any asset or collateral but is backed up by the reputation and integrity of the corporation that issues the debentures. This type of bond often bears a higher rate of interest than secured debentures to compensate investors for the additional risk of not having to repay their funds.  Although debentures are a type of bond, not all bonds are debentures. We will look at the difference between bonds and debentures in this article as well as other types of debentures and bonds.

What Is a Debenture Bond?

A debenture bond is a bond that is issued by a corporation and has no collateral security. Debenture bonds are a funding source that appears on the balance sheet as corporate obligations. Whenever a bond is insecure, you can say that it is a debenture bond but when the bond is secured it is called a secured bond. 

Difference Between Bonds and Debentures

A Bond and a debenture are both debt instruments that are issued by the government or a corporation. These are both fundraising instruments for the corporation. People interchangeably use these two words but in reality, they are not the same. Government, government agencies, or a major corporation issues a bond, while a debenture is issued by public firms to raise capital from the market. Bonds are the financial instruments government agencies and private organizations ensure, to raise additional funds from the public. While the private/public companies issue debentures for raising capital from the investors. Below are other differences between a bond and a debenture

  • Issuers secure bonds with their assets, whereas there is no tangible asset or collateral security for debentures. The creditworthiness and reputation of the issuing party enable them to purchase the debentures 
  • Bonds have lower interest rates than debentures. The lower interest rate represents the low-risk component. While debentures, pay a high-interest rate but are unsecured, therefore the risk factor is higher.
  • The interest on a bond is payable to the bondholder on a monthly, semi-annual, or annual basis. The interest amount never changes because the payable interest is not dependent on the issuer’s performance. In contrast, your interest rate may be high if you buy a debenture, but the interest payment will be periodical, depending on the issuer’s performance.
  • Bond investments have a low-risk factor, but debentures have a high-risk factor. Bondholdersusually receives preference during liquidation. 
  • You cannot convert bonds to equity shares, but you can transfer debentures to equity funds.

Types of Debentures

The following are the prominent types of debentures;

#1. Convertible Debentures

They are bonds that can convert into equity shares after a certain length of time. Convertible debentures are financial securities that combine the advantages of debt and equity. They are fixed-rate loans with fixed interest payments that many corporations employ.  However, debenture holders have the choice of either keeping the debt until maturity and receiving interest payment or converting the loan into equity shares.

Convertible debentures are appealing to investors who want to convert to equity because they anticipate the company’s stock will rise over time. However, the ability to convert to equity comes with a cost because convertible debentures pay a lower interest rate than other fixed-rate investments.

#2. Nonconvertible Debentures

Nonconvertible debentures are debentures that are not convertible into equity in the issuing corporation. Investors can receive a higher interest rate to compensate for the absence of convertibility when compared to convertible debentures. They may also prefer the convertibility characteristic of debenture bonds. As a result, convertible securities will have lower interest rates than their non-convertible counterparts.

Secured Debentures 

Secured debentures are debentures that are secured by a charge on the issuer’s fixed assets. For instance, mortgage debentures get their protection from the company’s land. Secured debentures bear less risk than unsecured debentures. The secured debenture’s agreement defines the terms and conditions of a loan thus stating the amount, interest rate, repayment period, and secured assets. For instance, a floating charge is when the debenture-holders have a charge on the entire property of a company.

Both present and future, and when it can deal with the property in the ordinary course of business until the charge crystallizes, i.e., when the company goes into liquidation or when there is a new receiver. A city, for example, might use future property tax receipts to secure a bond, whereas companies might use their factories as bond securities. A fixed charge asset in a secured debenture is generally an industrial or office building.

Secured debentures go with a fixed or floating charge. When the floating charge crystallizes, the debenture holders have a right to payment out of the sale profits of the assets, subject to the preferential creditor’s claim, but before any payment to unsecured creditors. This may cause a reduction in the coupon rates and cheaper borrowing costs for issuers. It is a bond that has its protection by a pledge of assets.

Types of Bonds

There are three major types of bonds

#1. Government Bonds

Globally, governments sell bonds and securities to produce money, fund government expenditure, and services and pay off debt. US government and agency bonds and securities have the US government’s “full faith and credit” guarantee which is one of the safest investments. That is, regardless of war, inflation, or the status of the economy the United States government repays its bondholders.

Treasury bonds, bills, and notes issued by the United States government are the highest-quality securities available. They are issued by the Bureau of Public Debt of the United States Department of Treasury. Treasury securities are all convertible and you can exchange them on the secondary market. Furthermore, you can differentiate them by maturity dates ranging from 30 days to 30 years. 

One significant advantage of Treasuries is that the interest they pay is tax-free at the state and municipal levels. The United States issues Treasury bills, treasury notes, and treasury bonds. Let’s look at them briefly

#1. Treasury Bills

Treasury bills pay no interest and have maturities ranging from a few days to 52 weeks. T-bills are short-term securities with maturities of less than a year. Because they sell it at a discount from their face value, they do not pay interest until maturity.

#2. Treasury Notes

These are fixed-income securities with maturities ranging from 2 – 3 years through 5, 7, and 10 years. Treasury notes (T-notes) have maturities ranging from one to 10 years and earn a fixed rate of interest every six months. The 10-year Treasury note is the benchmark for the mortgage market. They use it to analyze the performance of the United States government bond market.

#3. Treasury Bonds

Treasury bonds have maturities ranging from 10 to 30 years. They feature a coupon payment every six months like the like T-notes,

In addition to these  Treasury securities, certain government entities also issue bonds. As we said earlier, bonds come from the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal House Loan Mortgage Corp. (Freddie Mac) for specific reasons.

#2. Municipal Bond

The state and local governments issue municipal bonds (“munis”) to fund the building of schools, roadways, housing, sewer systems, and other significant public infrastructure projects. For investors who live in the jurisdiction where the local government issues the bond, these bonds are typically exempt from federal income tax and, in some situations, state and municipal taxes.

Munis typically offer competitive rates, but this is not safe because local governments can go bankrupt.

It’s worth noting that in some states, investors must pay state income tax; if they buy shares in a municipal bond fund that invests in bonds issued by states other than the one where they pay taxes. However, some municipal bonds in the fund may not be subject to ordinary income tax. They may be liable to federal, state, and local alternative minimum tax. Finally, if an investor sells a tax-exempt bond fund at a profit, he will need to consider the capital gains taxes

Municipal bonds are classified into two types. General obligation bonds and revenue bonds.  The issuer’s full faith and credit secure general obligation bonds and back them up with the issuer’s taxing power.

#3. Corporate Bonds

Corporations issue bonds to fund a substantial capital investment or a business development. Corporate bonds have a higher amount of risk than government bonds, but they typically have larger prospective yields. The value and risk that goes with corporate bonds heavily influence the company issuing the bond’s financial outlook and reputation.

The low credit rating bonds that companies issue are high yield bonds commonly known as junk bonds.  High-yield bonds give unique rewards and risks than investment-grade securities, including higher volatility, greater credit risk, and the issuer’s more speculative nature. Convertible bonds are one type of corporate bond. Bonds have varying maturities and are vulnerable to interest rates, inflation, and credit concerns.

Bond prices often fall as interest rates rise. Furthermore, bond returns and principal values fluctuate in response to changes in market conditions. Bonds may be worth more or less than their original cost if not held to maturity. Bond funds face the same inflation, interest rate, and credit risks as their underlying bonds. Prices normally decline as interest rates rise, which can harm the performance of a bond fund. Also, they use prospectuses to sell mutual funds.

Conclusion

Before you invest, carefully consider the investment objectives, risks, charges, and expenses. Your financial professional can provide you with the prospectus, Kindly read them carefully before deciding to make any investment.

What Is a Debenture Bond FAQs

What are debenture bonds used for?

Debentures, in general, serve more useful than other types of bonds. While you can use both the debenture and a bond to raise capital, it can be issued by a corporation to finance the expenses of an impending project or to pay for business development in view.

Is debenture an asset or liability?

Debenture bonds are business liabilities since they reflect future payable debts. On the balance sheet, liabilities are classified as either current liabilities or long-term liabilities.

Is debenture a loan?

Companies use debentures as fixed-rate loans with fixed interest payments. However, debenture holders have the choice of keeping the debt until maturity and receiving interest payments or converting the loan into equity shares.

What is the difference between shares and debentures?

Shares are the capital the company acquires. while debentures are the capitals the company borrows.

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