What is a Debenture?

A debenture is a form of debt instrument used by companies for borrowing money. In the US a debenture is not backed by any physical asset or collateral; rather, it is secured on the borrowers reputation and credit history. In the UK, in contrast, a debenture is based on the asset of the borrower.

How Does a Debenture Work?

So practically it is a kind of bond issued by both the corporate houses and governments to secure funds. It is a certificate of loan that ensures the company is liable to pay the stated amount with interest. In the U.S., the government issues debentures in form of Treasury bonds or Treasury bills. The buyers buy these bonds based on the trust that the government wont fail to pay back the amount with interest. There is no collateral involved in these. Debentures are the most common form of long-term loan taken by corporations with a fixed rate of interest and a fixed date of repayment. Usually, the corporations pay the interests of debentures before paying the dividends to its shareholders. Debentures are generally issued by the big corporations as they have reputation and reliability. In the U.S., the corporations issue debentures of around $1,000. For issuing a debenture, an agreement is signed between the issuing company and a trust that manages the interest of the prospective debenture holders. It is documented in an indenture. After that the interest rate of the debentures is decided, the rate can be fixed or variable.

Convertible and Nonconvertible Debentures

There are two types of debentures convertible and nonconvertible. The convertible debentures can be converted into equity share of the issuing company after a specific period of time, whereas the nonconvertible debentures do not have any such provisions. The interest rates of the nonconvertible bonds are higher than the convertible bonds. In the case of nonconvertible debentures, the company pays back to the debenture holder on the date of maturity. There are two ways of repaying the debenture holder depending on the terms of the bond. The most common way is paying a lump sum amount on the maturity date, it is called a redemption out of capital. The second option is paying a specific amount of fund yearly to the debenture holder until the whole amount is repaid on the date of maturity. It is known as debenture redemption reserve.