What is a Debenture?

A debenture is a bond issued with no collateral. Instead, investors rely upon the general creditworthiness and reputation of the issuing entity to obtain a return of their investment plus interest income. If the issuer of a debenture were to default, investors would be placed at the level of general creditors in terms of their ability to recover funds from the issuer. An entity that issues debentures and has lower credit quality can expect to pay a high interest rate, to compensate investors for the increased risk associated with these instruments.

Who Issues Debentures?

Debentures are normally only issued by the largest and most creditworthy of debt issuers, whose ability to repay is beyond question. For example, national governments can issue debentures, because they can raise taxes to pay off their obligations. These issuers use debentures in order to preserve their assets for use as collateral for more senior forms of debt. Further, they may see no need to use their assets as collateral, if investors are willing to pay for sufficiently low interest rates on any debentures issued.

Examples of Debentures

Here are several common examples of debentures:

Convertible debentures. These debentures can be converted into equity shares of the issuing company after a certain period, providing an option for investors to become shareholders. For example, a tech startup issues convertible debentures with a maturity of five years. If the company performs well, holders may convert their debt into equity, taking advantage of potential growth in stock value.
Non-convertible debentures. These debentures cannot be converted into equity and are repaid in full upon maturity. For example, a utility company issues NCDs with a fixed interest rate to fund infrastructure projects. Investors receive steady interest payments until maturity, with no option for equity conversion.
Secured debentures. These debentures are backed by specific assets or collateral, giving investors a claim to the collateral if the issuer defaults. For example, a real estate company issues secured debentures backed by its property holdings. If the company defaults, investors have rights to the underlying properties as repayment.
Unsecured debentures. These debentures are not backed by specific assets, meaning they rely solely on the issuer's creditworthiness. For example, a reputable pharmaceutical company issues unsecured debentures to fund R&D. Investors rely on the company's strong financial standing rather than asset collateral.
Redeemable debentures. These debentures are repaid at a specified date in the future. For example, an automotive company issues redeemable debentures that mature in ten years, at which time investors receive their principal amount back along with accumulated interest.
Perpetual debentures. These debentures have no maturity date, meaning they pay interest indefinitely without any obligation to repay the principal. For example, a telecommunications company issues perpetual debentures to raise capital, promising to pay annual interest as long as the debentures are outstanding.
Subordinated debentures. These debentures have a lower priority in case of liquidation, meaning they are paid after other debts are satisfied. For example, a bank issues subordinated debentures to enhance its capital base, which are paid only after other senior debts if the bank faces financial trouble.
Zero-coupon debentures. These debentures do not pay periodic interest. Instead, they are issued at a discount and redeemed at face value, with the difference serving as implied interest. For example, an airline issues zero-coupon debentures to fund fleet expansion. Investors buy at a discount and receive the full face value at maturity, effectively realizing a profit.