While a debenture might sound like a complex financial instrument, it simply represents a bond that has no particular assets collateralizing it. It is an unsecured bond, backed only by the general funds of the issuer. A nonconvertible debenture cannot be exchanged for common stock. Debentures are riskier than bonds backed by a specific asset, like the revenue generated from the operations of a hydroelectric dam or oil refinery.
Sometimes, a bond issuer runs short of money and has trouble paying the interest on a bond. Any delay in paying interest is called a default, as is the failure to pay back the principal on maturing bonds. A debenture has a higher default risk than the equivalent secured bond from the same issuer, because the securing asset can be claimed and sold for cash by holders of a defaulting secured bond. Secured bonds, also known as mortgage bonds, pay less interest than the equivalent debentures. Investors require higher interest rates from debentures to compensate them for taking on greater default risk.
You can exchange a convertible bond for common stock shares of the issuing company. The bond’s contract specifies the number of shares you get for each bond. This ratio can be used to calculate the minimum stock price that makes conversion profitable. If a stock’s market price approaches this conversion price, the price of the convertible bond will be pulled upward. Nonconvertible bonds have no such provisions and are thus less attractive to investors, who will demand a higher interest rate compared with the interest rate on convertible debt.
The issuer of a debenture can embed a call option into the bond. This option gives the issuer the right to forcibly redeem the bond for a preset price on or after the call date. Issuers like call options because they can recall bonds when interest rates fall and issue new bonds with a lower interest rate. Investors dislike calls for the same reason and demand a higher yield on these bonds.
A sinking fund debenture is an exception to the general rule that debentures are unsecured. A sinking fund is money set aside to retire some debt. A corporation can create a sinking fund before or after a bond is issued. Sinking fund money can redeem debentures in two ways. If the debenture is callable, the sinking fund will pay the call price on forcibly redeemed bonds, a price that is usually higher than the bond’s face value. Alternatively, the issuer can use sinking fund money to enter the bond market and buy back the debentures at their current price. Either way, sinking funds reduce default risk by reducing cash-draining interest payments.
Senior and Subordinated Debentures
If a corporation goes bankrupt and must be liquidated, the proceeds first go to the government and bondholders. If the corporation had sold multiple bond issues, a pecking order resolves the priority of repayments to bondholders. Secured bondholders are at the front of the line. Once they are paid, money is next distributed to debenture holders. Debentures can be priority-ranked and the top priority debenture is termed “senior.” Assuming there is any money remaining, the holders of subordinated debentures follow.
If You Want a Higher Return
To get the highest yielding bond from a particular issuer, look for nonconvertible subordinated debentures that are callable and not backed by a sinking fund.
- Bond Investing For Dummies, 2nd Edition ; Russell Wild
- Securities Fraud: Detection, Prevention and Control; Louis L. Straney
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.