Debenture

These are bonds with no collateral or security attached to them

Debentures are bonds or other debt instruments with no collateral or security attached to them. Due to the absence of security, unsecured bonds rely on the creditworthiness and reputation of the issuer. Corporations and governments are the organizations that frequently issue these to raise funds.

Debenture & Indenture

In the business world, you hear these terms. They might sound similar but are not. An indenture is a written agreement between the corporation and its creditors. They are also referred to as the deed of trust.

While a debenture bond is simply unsecured, I will thoroughly explain both terms to clarify any confusion.

In the Indenture are the provisions for the borrower to follow.

They are:

  1. The basic terms of the bonds.

  2. The amount of the bonds issued.

  3. A property description is used as security if bonds are secured.

  4. The repayment arrangements.

  5. The call provisions.

  6. Details of the protective covenants.

The basic terms of the bonds/ Amount of bonds issued

Bonds usually have a face value of $1000. This is the principal value, which can be seen on any bond certificate. So, for example, if a corporation wanted to borrow $500000, it would have to sell 500 bonds.

The bonds are usually in registered form, which records ownership of each bond, and payment is made directly to the owner of the record. In addition, it will record if the owner changes ownership throughout the time of maturity.

Another form corporate bonds partake in is the bearer form. This means bonds are issued without a record of the owner's name, and payment is made to whoever holds the bond.

Security

Security is classified as either collateral or mortgages used to protect the bondholder. 

Collateral

  • A general term that means securities (can be stock and bonds) pledged as security for debt payment.

Mortgage

  • Secured by a mortgage on the real property of the borrower. Involves real estate, transportation equipment, or other property.

The security section relates to debentures since most corporations issue unsecured bonds. Therefore, no specific pledge to the property is made. Another term used for unsecured bonds is known as a note.

A note indicates that the unsecured bond has fewer than ten years of maturity. We call them debentures when bonds have more than ten years of maturity.

Seniority

Seniority is used to showcase which lender has more priority than others. Therefore, they are sometimes labeled "junior" and "senior" to indicate seniority. 

Repayment

Bonds can be repaid at maturity, where the bondholder receives the stated value of the bonds, or they may be repaid in part or entirety before maturity. Early repayments are handled through sinking funds.

The Call Provision

The call provision allows the company to repurchase part or all of the bond issue over a specific period at a stated price. Most corporate bonds are callable.

Protective Covenant

It restricts specific actions the borrower can undertake during the loan term, usually to protect the lender's interests.

This overview sums up most of the sections in an indenture.

As you can see, it is unsecured security. So, the only part it relates to Indenture is the security section, where it will be labeled as so.

Understanding Unsecured bonds

In the same way, as most bonds, unsecured bonds pay periodic interest payments called coupon payments. As previously mentioned, they are also documented by an indenture in the security section.

Corporations and governments are the organizations that usually issue these. It is common for governments to issue bonds with more than ten years of maturity. These government bonds are low-risk investments since the government covers them.

Corporate unsecured bonds serve as long-term loans. However, they are unsecured. As a result, they are backed only by the financial viability and creditworthiness of the underlying company.

The interest rate on these debt instruments is fixed and can be redeemed or repaid on a fixed date. These debt interest payments are typically made before a company pays dividends to shareholders since it is debt.

Unsecured bonds benefit companies since they have lower interest rates and extended repayment periods than other loans and debt instruments.

Different types

Companies issue different types of unsecured bonds based on their objectives and requirements.

Convertible Debenture

These have convertible features which allow holders to convert their holdings into equity shares of the company. At the time of issuance, the company specifies details about holders' rights, the trigger date for conversion, and the conversion date, among other things.

  • Partly Convertible Unsecured I.O.Us

    • The issuing company can partially convert them into equity shares. The company determines the conversion ratio and date when the instrument is issued. As a result, holders enjoy both creditor and shareholder rights.

  • Fully Convertible Unsecured Bonds

    • They can be fully converted into equity shares by the issuing company. The conversion rate and conversion time are decided when the instrument is issued. Upon conversion, the holders enjoy the same status as the company shareholders.

  • Optionally Convertible Debentures

    • A debt holder can convert their debt into equity shares or not at a price determined by the issuer when the debt is issued.

Non-Convertible Unsecured I.O.U's

Non-convertible unsecured bonds are regular debt instruments that cannot be converted into equity. As a result, such instruments typically carry a higher interest rate than their regular counterparts.

What are the components of Unsecured Bonds?

Interest Rate

  • Represents the company's interest rate to pay the unsecured bondholder or investor.

  • This coupon rate can be either fixed or floating.

  • floating rate might be tied to a benchmark such as the yield of the 10-year Treasury bond and will change as the benchmark changes.

Credit Rating

  • Ultimately, the company's credit rating and the unsecured bond's credit rating determine the interest rate investors receive.

  • Credit-rating agencies measure the creditworthiness of corporate and government issues.

  • These entities offer investors a comprehensive overview of the risks associated with debt investments.

Maturity Date

  • By this date, the company must repay these holders.

  • Repayment can take a variety of forms.

  • Typically, this occurs as a redemption from the capital, where the issuer pays a lump sum upon maturity.

  • Payments can also be made using a redemption reserve, in which the company pays specific amounts yearly until full repayment is made at maturity.

Note

Moody's and Standard & Poor's credit rating agencies typically assign letter grades indicating the underlying creditworthiness. For example, Standard & Poor's system uses a scale to rate ranging from AAA to the lowest rating of C and D.

Any debt receiving a lower rating than a BB is said to be a speculative grade. Bonds that are in the speculative grade are also known as junk bonds.

Risks

Debentures are like any other bond other than unsecured, including all risks.

Inflation Risk

  • The risk is that the debt's interest rate may not keep up with the inflation rate.

  • Inflation measures economy-based price increases.

  • For example, say inflation causes prices to increase by 3%, and should the unsecured bond coupon pay at 2%, the holders may see a net loss in real terms.

Interest Rate Risk

  • Investors hold fixed-rate debts during rising market interest rates.

  • These investors may find their debt returning less than what is available from other investments paying the current, higher market rate.

  • If this happens, the unsecured bondholder earns a lower yield in comparison.

Default Risk

  • If the company struggles financially due to internal or macroeconomic factors, investors are at risk of defaulting on the unsecured bond.

  • As some consolation, these holders would be repaid before common stock shareholders in the event of bankruptcy.

Pros & Cons

Pros & Cons
ProsCons
These pay a fixed interest rate or coupon rate return.Fixed-rate unsecured bonds may have interest rate risk exposure where the market interest rate rises.
After a specified period, if you wish to do so, you can convert convertible unsecured bonds to equity shares, making them more appealing to investors.It is essential to consider creditworthiness when analyzing the chance of default risk from the underlying issuer's financial viability.
The unsecured bond is paid before common stock shareholders if a corporation goes bankrupt.Bonds may be subject to inflation risk if it does not keep up with the inflation rate.
These instruments are liquid and can be traded on the stock exchange.Default payment has adverse effects on the creditworthiness of the company.

Key Takeaways

  • Debentures are debt instruments such as bonds or I.O.Us that are not covered by collateral and have more than ten years of maturity.

  • An unsecured bond is only backed by the creditworthiness and reputation of its holder.

  • Both governments and corporations frequently issue these to raise funds.

  • Unsecured I.O.Us can convert into equity shares in some cases but not in others.

  • Holders are creditors of the company and are not permitted to vote in general meetings of the company until the company requests their opinion in exceptional situations.

  • It must be listed on at least one stock exchange.

  • Keynote: I.O.U's does not specify repayment details while a debenture does. However, we will use that term to describe unsecured bonds.

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Michael Rahme | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: