Debenture: advantages and disadvantages of this type of bond
A debenture is a term used to describe an unsecured bond. Such a financial instrument has no basis in the form of a physical asset or is not supported by collateral. In this case, the main collateral factor is the creditworthiness and reputation of the debenture holder. Companies and governments often use this type of bond issue as a tool for generating cash inflows. The issuance of a debenture is fixed in the bond contract along with other similar securities.
Whereas various assets are often used to pledge other bonds, such a mechanism does not work in the case of a debenture. Here, the acquisition of securities is based only on the trust in the issuer to be able to meet obligations and pay interest.
An example of this type of bond is the Treasury debenture or bill issued by the U.S. government. And these securities are considered risk-free because of the image of the government. The government will secure all obligations under the bonds in any case, even if it has to print money or raise taxes to do so.
There is also the concept of a senior unsecured bond, which is a direct debenture that gives its holder a number of advantages over a regular debenture. For example, if the issuer goes bankrupt, the holder of such paper has a priority right to receive the company’s assets and income. It should be noted that a senior unsecured bond, like other bonds, has no collateral in the form of assets.
If an issuer enters bankruptcy or is declared in default, the court will prioritize payments to all bondholders based on the company’s available assets. And payments to holders of senior notes, both secured and debentures, will come first, followed by holders of preferred stock and common stock.
Although unsecured shares have no basis in assets, they do have mechanisms to protect their holders’ interests. The most common is a covenant that restricts the issuer from providing collateral. In this case, the company issuing the debenture is not allowed to use its assets as assets for creditors.
International organizations and highly rated companies also issue unsecured bonds, but government bonds are the most popular among novice investors. In this case, the holder knows exactly what he or she is getting and does not risk capital. In addition, the acquisition of such bonds does not require any special skills and is carried out through mechanisms that are clearly regulated at the legislative level.
