Debentures: Definition and Examples
Debentures are debt instruments used by organisations to raise funds.
What is a Debenture?
A debenture is a long-term unsecured debt instrument issued by companies or governments to raise capital. They are distinct from traditional loans and bonds mainly because they do not require the borrower to pledge collateral. In other words, they are backed solely by the creditworthiness and reputation of the borrower.
When talking about debentures, the “issuer” is the corporation or government selling them to raise funds, whereas the investor is the individual or entity that purchases the debenture. The debenture is typically issued for a specified period of time, after which the principal is returned to the lender. Note, however, that some debentures are designed to have no fixed repayment date.
Since debentures are unsecured, the issuers must have a strong credit rating and a reliable financial history. The debenture holder receives periodic interest payments, known as coupon payments, throughout the term of the debenture. At the end of this term, known as the maturity date, the issuer repays the principal amount to the debenture holder.
Types of Debentures
Debentures are not a one-size-fits-all financial instrument. They come in various types, each with their own set of features, benefits, and drawbacks. Here are some common types:
- Registered vs. Bearer: Registered debentures are recorded in the issuer register, and all transactions must be noted within that registry. Bearer debentures, on the other hand, belong to the holder in possession and don’t require such registration, making them more easily transferable.
- Redeemable vs. Irredeemable: Redeemable debentures have a fixed maturity date, requiring the issuer to repay the principal amount by that time. Irredeemable debentures (or perpetual debentures) have no such maturity date, making them more flexible for the issuer but riskier for the investor.
- Convertible vs. Non-Convertible: Convertible debentures can be transformed into equity shares of the issuing company after a specific period. This conversion is typically at the discretion of the debenture holder. Non-convertible debentures remain as debt for their entire term.
Pros and Cons of debentures
While debentures offer a compelling avenue for companies to raise capital, they come with their own set of advantages and disadvantages. Understanding these can help investors and corporate leaders make more informed decisions.
Pros of debentures
- Regular Income for Investors: Debentures pay a fixed interest rate at regular intervals, providing a steady income stream for investors.
- No Dilution of Ownership: For companies, issuing debentures avoids the dilution of ownership that comes with issuing more shares.
- Tax Benefits: The interest payments on debentures are tax-deductible for the issuing company, offering a financial advantage.
- Priority in Repayment: In the event of bankruptcy, debenture holders are among the first to be repaid, before equity shareholders, making it a relatively safer investment option.
Cons of Debentures
- Interest Rate Risk: Fixed-rate debentures may become less attractive if market interest rates rise, reducing their market value.
- No Voting Rights: Debenture holders do not have voting rights in the company, limiting their influence over corporate decisions.
- Credit Risk: Because debentures are unsecured, the risk of default by the issuer is higher compared to secured debt instruments.
- Inflation Risk: The fixed interest payments may not keep up with inflation, eroding the real value of the investment over time.
Debentures vs. Bonds
Debentures and bonds are often used interchangeably, but they are not the same. Both are debt instruments, but there are key differences:
- Security: Bonds can be either secured or unsecured, while debentures are always unsecured.
- Maturity: Bonds can have short, medium, or long-term maturities, whereas debentures typically have long-term maturities.
- Interest Rates: Due to the higher risk associated with the lack of collateral, debentures usually offer higher interest rates than bonds.
- Convertible Option: debentures may offer the option to convert into shares of the issuing company, an option seldom found in bonds.
Accounting for Debentures
In financial statements, debentures are included in the long-term liabilities section under Long-Term Debt.; They do not usually appear as a separate line item, but may be detailed in the notes accompanying the financial statements. The interest payments related to debentures are often shown in the income statement under & “Interest Expense”.
Finding debentures in a Company's 10-K Report
While debentures don’t usually appear as a distinct entry on a balance sheet, they are generally encompassed under long-term liabilities, specifically within the & “Long-Term Debt” line item. To delve into the specifics, one must consult the notes section in the company’s 10-K report, where details about various types of debt, including debentures, are usually disclosed.
For example, consider the case of AT&T. In their 10-K filing for the fiscal year ended December 31st, 2022, we can see that their balance sheet includes long-term debt of around $128 billion:
In order to get a better understanding of the composition of this debt, it is necessary to dig further into the notes to their financial statements. In this instance, we can find the information we are looking for on page 71, where the company discloses additional details within Note #11:
Additional Resources
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