What it means
Companies need long-term money for long-lived assets, and borrowing it for a fixed term at a fixed rate is often cheaper and less dilutive than issuing shares. A debenture is the traditional instrument for doing so.
The company issues certificates, or in modern markets electronic entries, to investors who lend the money; the terms are set out in a trust deed or indenture that specifies the interest rate (the coupon), the payment dates, the repayment date and amount, any security, the covenants the company must observe, and the events that would put the company in default. A trustee is usually appointed to represent the holders collectively, so that the company deals with one party rather than hundreds and the holders can act together if the company breaches its obligations.
The meaning of the word varies by jurisdiction, and the difference matters. In the United Kingdom, Australia, India and other Commonwealth countries, a debenture is generally a secured instrument: the trust deed creates a fixed charge over specific assets such as land and buildings, a floating charge over the company's circulating assets such as inventory and receivables, or both.
If the company defaults, the trustee can enforce the charge and appoint a receiver to realise the assets for the benefit of the holders. In the United States, the same word means an unsecured bond; secured bonds are called mortgage bonds or collateral trust bonds.
A reader of company accounts or a bond prospectus must check which meaning applies. Debentures come in several forms.
Redeemable debentures are repaid on a fixed date or over a schedule; irredeemable or perpetual ones pay interest indefinitely. Convertible debentures give the holder the option to exchange them for shares at a set price, which lets the company pay a lower coupon in return for the equity upside.
Registered debentures record the holder's name; bearer debentures, now rare, are payable to whoever holds the certificate. Debenture stock is a single debt divided into units so that it can be traded.
Subordinated debentures rank behind other creditors and carry a higher coupon to compensate. From the company's side, the cost of a debenture is the coupon plus the effect of any issue discount and issue costs, spread over the term as an effective interest rate.
Accounting standards require the liability to be shown initially at the net proceeds and then carried at amortised cost, with the interest expense each year being the effective rate applied to the carrying amount, so that the discount and costs are charged through the income statement over the life of the instrument rather than when paid. Interest is generally tax deductible, unlike dividends, which lowers the after-tax cost.
The obligations are the price: interest must be paid whatever the profits, covenants must be met, and security given to debenture holders is not available to other lenders. From the investor's side, a debenture is a fixed-income investment whose attractions are predictable income and priority over shareholders, and whose risks are default, inflation eroding the fixed payments, interest rates rising and reducing the market value of the fixed coupon, and, for convertibles, the terms of conversion.
Secured debentures with strong covenants and a healthy cover of assets and earnings are among the safer corporate investments; unsecured, subordinated or long-dated ones carry more risk and pay more for it.
In practice
Real-world examples.
Example
A property company issues $50,000,000 of 6% debentures secured by fixed charges over three office buildings, repayable in fifteen years, and uses the money to buy a fourth.
Example
A technology company issues $30,000,000 of 4% convertible debentures, convertible into shares at $25 when the shares trade at $18; investors accept the low coupon for the chance to convert if the shares rise.
Example
A United States industrial company issues $200,000,000 of senior unsecured debentures at 5.5%, ranking alongside its bank borrowings and ahead of its subordinated notes.
Think of it
“A debenture is an unsecured bond-backed by the company's promise to pay, not specific assets.
Formula
Calculation
Annual cash interest = Nominal value x Coupon rate
Net proceeds = Nominal value x Issue price minus Issue costs
Effective interest rate = the rate that discounts the cash flows to the net proceeds (solved by trial or a spreadsheet)
Interest expense (year) = Opening carrying amount x Effective interest rate
Closing carrying amount = Opening carrying amount + Interest expense minus Cash interest paid
Interest cover = Operating profit / Interest expense
Worked example. A company issues $20,000,000 of 8% five-year debentures at 97 (that is, $97 for each $100 of nominal), repayable at par, with issue costs of $300,000. The debentures are secured by a fixed charge over the company's property, valued at $12,000,000, and a floating charge over inventory and receivables of $15,000,000.
- Cash interest = $20,000,000 x 8% = $1,600,000 a year
- Net proceeds = $20,000,000 x 97% minus $300,000 = $19,400,000 minus $300,000 = $19,100,000
- Total cost over the term = 5 x $1,600,000 + ($20,000,000 minus $19,100,000) = $8,000,000 + $900,000 = $8,900,000
- Effective interest rate: the rate at which $1,600,000 a year for five years plus $20,000,000 at the end of year five discounts to $19,100,000 is about 9.15%; at 9% the present value is about $19,220,000 and at 9.2% about $19,070,000
- Year 1 interest expense = $19,100,000 x 9.15% = about $1,748,000; cash paid $1,600,000; the difference of about $148,000 is added to the liability, which becomes about $19,248,000
- The carrying amount rises each year in the same way and reaches $20,000,000 at redemption
Interest cover. Operating profit is $6,400,000, so cover on cash interest is $6,400,000 / $1,600,000 = 4.0 times, comfortably above the 3.0 times minimum in the trust deed. Asset cover: the charged assets of $27,000,000 cover the $20,000,000 debt 1.35 times.Case study
Seen in the real world.
A family-owned manufacturing company needed $10,000,000 to build a new plant and, unwilling to sell shares to outsiders, issued 8% ten-year debentures to a group of private investors introduced by its bank, secured by a fixed charge over the existing factory. The trust deed required interest cover of at least 3.0 times, tested annually, and gave the trustee the right to demand immediate repayment if the covenant was breached. At the time of issue operating profit was $3,000,000, so cover was 3.75 times, and the directors regarded the covenant as a formality.
Three years later a downturn in the company's main market cut operating profit to $1,700,000. Interest of $800,000 gave cover of 2.1 times, a breach. The trustee had the right to call the $10,000,000 immediately, which the company could not pay; enforcement of the fixed charge would have meant selling the factory.
The company had no choice but to negotiate. The holders, who preferred a performing loan to a forced sale, agreed a waiver in return for terms: the coupon rose from 8% to 9.5% for the remainder of the term, a waiver fee of $100,000 was paid, the covenant was reset at 2.0 times for two years, and the holders received warrants over 5% of the company's shares. The extra interest was $150,000 a year, and the family had given away a small piece of the equity it had borrowed to protect.
The company recovered and repaid the debentures at maturity, but the episode changed how the board thought about debt. It had treated the covenant as a formality and the security as a paper matter; in fact the covenant had converted a routine downturn into a negotiation in which the other side held the factory. The lesson the finance director recorded was that a debenture's cost is not only its coupon but its terms, and that headroom under covenants is worth paying for.
Watch out
Common mistakes.
- Assuming a debenture is secured or unsecured without checking the jurisdiction and the deed; the word means different things in British and American usage.
- Charging issue discounts and costs to profit in the year of issue rather than spreading them through the effective interest rate over the term.
- Treating covenants as formalities; a breach gives the holders rights that can force a company into a negotiation on their terms.
Questions
People also ask.
What is the difference between a debenture and a bond?
In American usage, a debenture is an unsecured bond. In British usage, a debenture is usually a secured long-term debt instrument, and "bond" is the broader term. In practice the words overlap and the deed defines the terms.
What is the difference between a debenture and a loan?
A bank loan is a private agreement with one lender; a debenture is an instrument issued to investors, often tradeable, documented in a trust deed with a trustee representing the holders. Both are debt and both rank ahead of shareholders.
Do debenture holders have any say in the company?
No, unless the company defaults. They are creditors with a right to interest and repayment, not owners with votes. A trust deed may give them the right to approve certain actions, such as further secured borrowing, through the trustee.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related