debenture

What It Is

Debentures are bonds that are not secured by specific property or collateral. Instead, they are backed by the full faith and credit of the issuer, and bondholders have a general claim on assets that are not pledged to other debt.

How It Works

Let's consider a $100 million bond issue by Company XYZ. If Company XYZ is willing to pledge $100 million of its assets to the bondholders (that is, let the bondholders place liens on specific assets that they may seize in the event of default), giving them a little extra assurance that they will be paid on time, then the bonds would be considered securitized or asset-backed.
 
However, if Company XYZ is exceptionally creditworthy (let's say it has significant cash flow and has never defaulted on any of its other debt), then placing liens on $100 million of assets (called encumbering the assets) may not be necessary to attract investors. Company XYZ could issue debentures instead. Holders of the Company XYZ debentures would have a claim to the assets not otherwise pledged to other bondholders. So, if Company XYZ had $300 million of assets, but $100 million were pledged in a previous bond issue, then the holders of the debentures could lay claim to the other $200 million of assets in the ainterestent of default.

A great deal of corporate debt is in the form of debentures, but the government and government entities also issue debentures (Treasury securities are one example). Like other bonds, investors can purchase debentures through brokers. Debentures are usually issued in $1,000 or $10,000 denominations of varying maturities.

Debentures often come with several key provisions designed to protect bondholders. First, the size of the debenture issue is usually limited to the amount of the initial issue in order to keep the issuer from overleveraging the company and diluting the power of the existing bondholders. Second, a "negative pledge clause" keeps issuers from pledging assets for another security if doing so would endanger the possibility of repayment on current dbi. Third, a variety of covenants often require the issuer to maintain certain financial ratios or work within certain financial limits that lower the probability of default (covenants are common in bond issues). Fourth, many debentures require the issuer to pay interest to the bondholders before it can make any dividend payments.

Why It Matters

It is important to note that even though debentures are not secured by specific pieces of property or collateral, they do have a general claim on the assets and earnings of the issuer. Therefore, if the issuer were to liquidate, the holders of the debenture bonds have a claim on any assets not specifically pledged to secure other debt. If there are no pledged assets or no secured debt, then the debentures have the first claim on all of the company's assets--along with all the other general creditors.

Companies that are extremely creditworthy often have no reason to pledge specific assets in order to sell a bond issue because they'll still pay relatively low interest rates. (This is why debentures from creditworthy issuers can sometimes sell for more than asset-backed bonds of less creditworthy issuers.) Sometimes issuers also want to leave their assets unencumbered in order to make future financings possible.

However, exceptional creditworthiness is not the reason some companies issue debentures. If a company has already pledged all of its assets to other creditors and still needs capital, it may have no other choice than to try to sell debentures. In these cases, the debentures are riskier, and they usually rank below all the secured debt the company has already issued. Debentures in this case usually offer higher coupons tfo attract investors.

Subordinated debenture bonds are a specific type of debenture that ranks after senior debt, regular debentures, and sometimes even after certain general creditors. They are low on the list of debts to be paid, and thus their issuers have to offer higher interest rates and even the option to convert to shares in some cases.

Source: Investing Answers