This article will outline the different types of debentures.
Table Of Contents
What is a Debenture
Debentures are long term debt instruments issued or sold by private corporate entities that pay coupons (interest payments) and return the face value at maturity. They are the most common type of debt capital market instruments issued for long term capital needs. Debentures have two important features, periodic interest payments and repayment of the principal amount at a certain point in time. A contract that states the terms and conditions of the loan, payment of interest, repayment of the loan and any security offered is agreed upon between the issuer and the debenture holder. The classification of debentures is based on their tenure, redemption, convertibility, security and transferability among other factors. The various types of debentures are registered debentures, bearer debentures, redeemable debentures and collateral debentures to name a few.
A registered debenture is a type of debenture that is payable to the registered holders. The name, address, and other details of the holder are registered with the issuing company. The debenture can be transferred to another person, but the details of the new holder have to be registered with the issuing company. The names of the holders appear in the company’s register of debenture holders.
This type of debenture is an unregistered debenture that can be transferred easily. Bearer debentures are said to be as good as currency notes because of their easy transferability.
Redeemable debentures are types of debentures that can be redeemed after a specific time frame. The company issuing the debenture is obliged to repay the principle amount to the debenture holders on the date of redemption.
Irredeemable or Perpetual Debentures
These types of debentures are redeemable by chance, they do not carry any date of redemption. Perpetual debentures can only be redeemed on the liquidation of the company or in accordance with the terms of the agreement when the company decides to reduce their liability.
These are debentures that can be converted into equity shares. The date of conversion, the rate of conversion or the number of shares per debenture are agreed upon and written in the terms and conditions of the agreement at the time of issue.
These types of debentures are simple debentures that cannot be converted into equity shares.
Fully and Partly Convertible debentures
Fully convertible debenture can be converted into equity or shares. Partly convertible debentures have 2 parts; the part that is converted into equity based on an agreed rate and a part that is non-convertible. The non-convertible part is redeemed after an agreed period.
These types of debentures have specific collateral backing them in the event of bankruptcy. They are secured by a charge on an asset or a set of assets. They are also known as mortgaged debentures. A trustee is appointed for holding the secured asset. These debentures are further classified into first and second mortgaged debentures. The first mortgaged debenture has the first charge over the assets of the company whilst the second mortgage debenture has the secondary charge. This means that when the assets are liquidated the obligation of the first mortgage debentures will be fulfilled first followed by the obligation of the second mortgage debentures.
Companies can issue debentures without a mortgage or a charge on the company’s assets. Simply put these debentures have no collateral. Such types of debentures are called unsecured or naked debentures. Naked debentures are simply an acknowledgement of a debt due from the company.
Fixed Rate Debentures
Fixed rate debentures are debentures that have a fixed interest rate over the life of the debentures.
Floating rate Debentures
These types of debentures unlike fixed interest rate debentures, have a floating rate of interest which is dependent on a benchmark such as the prime lending rate. That means they allow for interest payments that are tied to some measure of current market interest rates. For example, the interest rate might be adjusted annually to the current treasury bill rate.
Zero Coupon Debentures
Also known as deep discount bonds, these are debentures that do not carry any coupon rates, meaning that the holder will not obtain any interest payments. Instead, zero-coupon debentures are issued at a discount but redeemed at face value.
Secured Premium Notes/Debentures
Secured premium debentures are types of debentures that are secured and issued at par but redeemed at a premium.
Callable and Puttable Debentures
Debentures sometimes come with options attached. Callable debentures are debentures that can be redeemed by an issuing firm before the expiration date for a stipulated call price. If companies issue callable debentures with high interest rates, when market interest rates increase they can repurchase the debentures when market interest rates fall in order to reduce interest payments. Companies use the proceeds of new debentures to pay for the repurchase of the higher coupon debentures. Puttable debentures are debentures that a holder can sell back to the issuing company. If the debenture’s coupon rate exceeds current market yield, the holder can choose to extend the term of the debenture. If the coupon rate is too low, the holder can reclaim the principal which can be invested at current yields.
Subordinated debentures are debentures that are redeemed only after other debts are paid off in the event of liquidation. These types of debentures have a lower priority claim on a company’s assets in the event of bankruptcy. They are normally issued with a higher return since they are riskier than other debentures.
Difference between Debentures and Government Bonds
Debentures are structured much like treasury issues, they typically pay semi-annual coupons over the life of the debt instrument and return the face value of the holder at maturity. The main difference between government bonds/treasury bonds and debentures is the risk involved. Debentures carry more risk than treasury bonds. If a company becomes bankrupt the debenture holders may not receive the payments they have been promised. The actual payments of debentures is uncertain because they depend on the ultimate financial status of the firm.