What is a debenture?
A debenture is an instrument used by a lender, such as a bank, when providing capital to companies and individuals. It enables the lender to secure loan repayments against the borrower’s assets – even if they default on the payment.
A debenture can grant a fixed charge or a floating charge. A fixed charge is normally taken out against a tangible asset such as property. It enables the lender to take ownership of the borrower’s assets and sell them off in the event of a payment default. With a fixed charge, the borrower would not be able to sell the asset without the lender’s consent.
A floating charge – which is usually attached to assets such as shares, raw materials and intellectual property – implies that the assets may change over time, and the borrower can sell them without the lender’s intervention. However, floating charges may become fixed if the borrower defaults.
US vs UK debentures
In the US, the term debenture takes on a slightly different meaning to the UK. In the US, a debenture is a medium to long-term loan, issued to a company by an investor. Think of it as an unsecured loan that is supplied in good faith – unlike UK debentures, the loan is not backed up by physical assets; only by the company’s good reputation in the eyes of the investor. The loan must be settled at a fixed interest rate, but the money raised is used as capital for the business.
There are two types of debentures in the US – convertible and non-convertible. A convertible debenture can be exchanged for the company’s shares during a certain period and often offer lower interest rates. A non-convertible debenture cannot be converted into shares and often carries a higher interest rate.
If the company defaults on the loan, the investor may claim any tangible assets, even if they were not pledged on the initial agreement.
How do debentures work?
Put simply, the borrower issues a debenture via an agreement called an indenture. Depending on the country of issue, this agreement outlines details such as the amount of the loan, its convertibility, interest rate and maturity date. Then, the investor lends the funds to the borrower and expects repayments at the agreed interest rate.
Example of a debenture
Let’s say company ABC issues a debenture to the value of CHF 100,000, redeemable on 31 December 2019. This is the date on which the company will receive the loan back. It bears 5% interest per year, payable on 31 July every year. An investor agrees to offer the loan at a fixed charge. If ABC defaults on the payment, the investor may now sell the company’s assets to raise the capital needed to fulfil the loan.
Pros and cons of debentures
Pros of debentures
Pros for the lender
Debentures can be financially rewarding for investors because they pay interest – usually at a much higher rate than bonds or other investments. Another benefit to investors is that convertible debentures can be exchanged for shares. Lastly, debentures are transferrable between financiers, so an investor does not have to hold onto the debenture if they don’t want to.
Pros for the borrower
Debentures provide funds for the company or individual, and the loans are not restricted in terms of how much they can borrow – unlike regular loan options.
Cons of debentures
Cons for the lender
Debentures carry different types of risk, including interest rate risk and inflationary risk. Because debentures are repaid on a fixed interest basis, the lender may lose out if interests rates rise. Furthermore, interest payments may not be in line with changing inflation.
Cons for the borrower
The downside for the borrower is that they have little financial flexibility because the interest payments are compulsory. And, if they cannot repay the loan, they may suffer other losses, as outlined in the indenture. This means that the company who issues the debenture may lose more than they borrowed.
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