Debentures are a form of medium to long-term debt that many companies use to help fund their business. They are also often known as “Corporate Bonds”, “Loan Notes” or “Loan Stock”.
Whilst any company may use debentures they are more commonly used by large and/or listed companies.
How do they work?
If a company wishes to raise money using debentures it will first decide how much it wants to raise. It will then consider what it needs to offer to potential investors or lenders in order to gain those funds. In particular, it will therefore determine the interest rate to be offered on the money to be raised, when the interest will be paid and when the capital borrowed will be repaid.
For example, a company might want to raise £1,000,000 and in order to obtain this amount it believes it will have to offer an interest rate of 8% per year which will be paid annually and that the capital of £1,000,000 will be repaid 10 years after the date the debentures are issued.
The amount to be raised will usually be broken down into blocks (typically of £1,000). These “blocks of debt” are then offered to investors. The price they will be offered at can vary, on this course however, we will always make the assumption that they have been offered at par (i.e. their nominal or face value) but they could be offered at a lower price (i.e. “at a discount”) or at a higher price (i.e. “at a premium”) depending on circumstances. The investors buy the debentures in return for an agreement from the company to pay the interest as agreed and pay the capital at the agreed time.
Gaia plc wishes to raise £1,000,000 by issuing 1,000 debentures of £1,000 each. The debentures will be issued on 1st January 2021 at par, i.e. for £1,000 each. Debenture holders will be entitled to receive interest at a rate of 6% per annum which will be paid in a single instalment each year on 31st December. The debentures will be repaid at par on 31st December 2031 at which point they will be cancelled.
Two investors purchase the debentures; Simone who purchased 400 for £400,000 and Justine who purchased 600 for £600,000. Simone will therefore be entitled to receive £24,000 of interest from the company each year and Justine will be entitled to £36,000 of interest each year. Their capital of £400,000 and £600,000 will be repaid to them on 31st December 2031.
An individual has purchased £160,000 of debentures in a company at their par value. The debentures carry an interest rate of 4.25% per annum, payable in two instalments in June and December each year.
How much interest will the individual receive in June?
Other features of a debenture
Once an investor has purchased debentures in a company, they can sell some or all of them to a third party. This can be attractive to those investors/lenders who might want to obtain the value of the debentures before the date the company is due to repay them.
Another feature of debentures is that they include rights over the assets of the company if the company fails to pay the interest or capital repayments as agreed. This reduces the risk being taken by debenture holders in giving money to the company.
Alternative meaning of debenture
In the UK, the term debenture can also be used to refer to the security given to a lender by a borrower. So for example, a company might borrow money from a bank and offer its property as security. This means that if the money is not repaid as agreed, the bank will have the right to take control and sell the property and use the proceeds from the sale to repay the loan. This security is recorded in a document called a debenture.
In this course however, we will simply use the term debenture to mean a form of debt as described above.