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Tuesday, April 12, 2011

What debentures are and how they work

Debentures are financial instruments used to raise capital that offer borrowers the chance to finance their business without forfeiting control of company ownership. Issuers of debentures are typically either government agencies or businesses, and debentures are also referred to as bonds. However, these types of bonds are' un-collateralized' i.e. not secured by collateral assets, making their success in generating funds largely dependent on the credibility of the issuer, and the return on investment to the lender.


• Purpose

Debentures are an alternate source of capital investment financing. They may however, be used alongside other types of financing to better suit the borrowers goals. For borrowers debentures help finance projects, business expansion and operational objectives that are believed to contribute to their organization's financial success. Lenders partake in debentures because they can receive a stable growth of investment in the case of high-grade debentures, while also hedging risk from other investments such as stocks.

• Terms

The borrower and lender terms of agreement that circumscribe the bondholder's rights are called 'indentures'. These are legal loan contracts that define how the debentures will be paid back, the time by which this will happen, how the debentures will be beneficial to the lender and any other requirements, restrictions, waivers etc. that the involved parties agree to. The process with which debentures are issued and sold is called underwriting; in some cases this process may involve third parties such as investment banks.

• Interest

Interest rates or borrower costs vary considerably with debentures but can be as high as 25% or higher.(3) The indenture, financial solvency of the issuer, and the market in which the debentures are exchanged influence the rate debentures yield. Essentially, the higher risk the company and the more restrictive the indenture is, the greater the interest rate should be to compensate for the accompanying risks to the lender.

• Types

Several types of debentures exist, not all of which are available for consumer investments.(1) Agency debentures are government debentures according to Investopedia, whereas corporate and convertible debentures are issued by companies; the latter of these can be converted to equity i.e. shares. Not all debentures are subject to the same lender obligations, an example being subordinated debentures that do not give priority to the debenture holder in the event of corporate insolvency.(3) Other types of debentures include redeemable and mortgage debentures.(5)

• Benefits

The benefits of debentures may include both a high and relatively low risk return on investment (ROI) for lenders depending on the type of debenture. In other cases, the interest paid by the debenture may be fairly low as is the case with several types of Government debentures. Mutual funds that invest in bonds may offer investors an opportunity to invest in debentures that would otherwise be inaccessible. The benefits for corporations generally assume an Internal Rate of Return (IRR) that is forecasted to be higher than the cost of the debenture(s) in addition to achieving business developmental or operational goals.

Sources:

1. http://bit.ly/9Vdpsy (Treasury Direct)
2. http://bit.ly/8Zy8YH (Investopedia)
3. http://bit.ly/d7lTAl (Mojo Law)
4. http://bit.ly/ax7dYP (Small Business Administration)
5. http://scr.bi/bdqA1z (Scribd)