A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of debt instrument when they need to borrow money.
Debentures have a fixed term of repayment and pay interest to the debenture holder at a specified rate. At the end of the term (maturity), the principal amount is repaid to the debenture holder. In the event of bankruptcy, debenture holders are considered unsecured creditors and are paid out after secured creditors.
There are two main types of debentures:
- Convertible Debentures: These can be converted into equity shares of the issuing company after a specified period of time. This is at the discretion of the debenture holder. Convertible debentures are attractive to investors as they allow them to benefit from any appreciation in the company’s share price.
- Non-Convertible Debentures: These cannot be converted into equity shares and will repay the principal amount along with the interest at the time of maturity.
Debentures are a common way of raising loan capital. The holders of the debentures are, therefore, essentially creditors of the company.
Example of a Debenture
Let’s say a company named “TechFusion Inc.” wants to raise capital for a new project. Instead of issuing more shares and diluting the ownership, the company decides to issue debentures.
TechFusion Inc. decides to issue 1,000 debentures, each with a face value of $1,000. These debentures carry an annual interest rate of 5% and have a maturity of 10 years. This means TechFusion Inc. is looking to raise $1,000,000 ($1,000 x 1,000 debentures) from the market.
Investors who buy these debentures become creditors of TechFusion Inc. The company is obligated to pay these debenture holders a 5% interest each year. So, if an investor purchases one debenture for $1,000, they would receive $50 (5% of $1,000) per year as interest income.
At the end of 10 years, TechFusion Inc. would repay the principal amount of $1,000 to the debenture holder, regardless of the company’s financial condition or market value.
If these were convertible debentures, the holders would have the option (but not the obligation) to convert these debentures into equity shares of TechFusion Inc. at a predetermined rate at some point during the lifespan of the debenture. This could be beneficial if the company’s share price appreciates significantly.
In the case of non-convertible debentures, the holders would only receive the interest payments and the return of their principal at maturity, with no option to convert to equity.