Question

Explain why do lenders need to hold a debenture?.

Answer 1

Debentures are an instrument available to business lenders in the UK, allowing them to secure loans against borrowers’ assets. Put simply, a debenture is the document that grants lenders a charge over a borrower’s assets, giving them a means of collecting debt if the borrower defaults.

Debentures are commonly used by traditional lenders, such as banks, when providing high-value funding to larger companies. To register a debenture, a lender simply has to file it with Companies House. This can usually be done in a matter of days.

Similar to most bonds, debentures may pay periodic interest payments called coupon payments. Like other types of bonds, debentures are documented in an indenture. An indenture is a legal and binding contract between bond issuers and bondholders. The contract specifies features of a debt offering, such as the maturity date, the timing of interest or coupon payments, the method of interest calculation, and other features. Corporations and governments can issue debentures.

Governments typically issue long-term bonds—those with maturities of longer than 10 years. Considered low-risk investments, these government bonds have the backing of the government issuer.

Corporations also use debentures as long-term loans. However, the debentures of corporations are unsecured.12 Instead, they have the backing of only the financial viability and creditworthiness of the underlying company. These debt instruments pay an interest rate and are redeemable or repayable on a fixed date. A company typically makes these scheduled debt interest payments before they pay stock dividends to shareholders. Debentures are advantageous for companies since they carry lower interest rates and longer repayment dates as compared to other types of loans and debt instruments.

Debenture Risks to Investors

Debenture holders may face inflationary risk.5 Here, the risk is that the debt's interest rate paid may not keep up with the rate of inflation. Inflation measures economy-based price increases. As an example, say inflation causes prices to increase by 3%, should the debenture coupon pay at 2%, the holders may see a net loss, in real terms.

Debentures also carry interest rate risk.5 In this risk scenario, investors hold fixed-rate debts during times of rising market interest rates. These investors may find their debt returning less than what is available from other investments paying the current, higher, market rate. If this happens, the debenture holder earns a lower yield in comparison.

Further, debentures may carry credit risk and default risk.6 As stated earlier, debentures are only as secure as the underlying issuer's financial strength. If the company struggles financially due to internal or macroeconomic factors, investors are at risk of default on the debenture. As some consolation, a debenture holder would be repaid before common stock shareholders in the event of bankruptcy.

The different types of debenture charge

There are two types of charge that can be granted by a debenture, with lenders tending to seek one or both of the following.

Fixed charge

With this type of charge, a lender can ensure it is the first creditor to recoup any outstanding debt if a borrower defaults on a loan. In essence, it grants the lender possession and ownership of a borrower’s asset in the event of non-payment, with any subsequent sale being used to pay off the remaining debt. The most common form of fixed charge is against property.

As well as covering the freehold or leasehold of a property, a fixed charge can cover building fixtures, trade fixtures, fixed plant and machinery, and motor vehicles. With a fixed charge, the borrower would not be able to sell the asset without the lender’s permission, and the proceeds would usually go to the lender or towards a new asset, which the lender then places a fixed charge over.

Floating charge

A floating charge can be attached to all of a company’s assets, or specific classes of asset, including stock, raw materials, debtors, vehicles, fixtures and fittings, cash, and even intellectual property. The ‘floating’ nature of the charge means these assets might change over time, with the borrower able to move or sell any assets during the normal course of business.

It’s only when the lender looks to enforce the debenture in a default situation that the floating charge ‘crystallises’ and effectively becomes a fixed charge. From that point, the borrower will no longer be able to deal with the assets in question, unless they have permission from the lender. In an insolvency or liquidation, a floating charge will give a lender priority over unsecured creditors when it comes to the allocation of repayments.

Multiple Debentures

It is possible for a lender – or lenders – to have multiple debentures on the same borrower. These can either be multiple fixed debentures against different specific assets, multiple floating debentures, or a mixture of both. When the first lender places a debenture on the company, they often prevent a second lender adding another without their consent.

Where there are multiple lenders with debentures that have recourse against the same borrower’s assets, the lenders will agree priority of payments between themselves. This is usually documented between the lenders and borrower by way of a Deed of Priority.

Debentures - good or bad?

In essence, debentures are a necessary evil of raising money for a business. Some lenders won't lend above a certain amount without a debenture, so regardless of how much you’re looking to borrow, you should be prepared to offer up your assets as security.

If you're uncomfortable putting your company's assets on the line, an unsecured loan might be a better option for your business, although it could mean borrowing less and paying a higher rate of interest.

Steady on, Donald!

If you’re reading this article in the USA, you can ignore the above, unless you found this page as part of your research into the UK finance industry.

Believe it or not, ‘debenture’ means something completely different in the United States. Rather than an instrument that’s used to secure a loan against company assets, a debenture in the USA is an unsecured corporate bond that companies can issue as a means of raising capital.

With no collateral involved, this type of debenture is backed only by the reputation and creditworthiness of the business that’s issued it. As such, anyone investing in a debenture in the USA does so on the belief that a company will have no trouble making repayments.

There are two types of debenture in the United States: convertible and non-convertible.

Convertible debentures

A convertible debenture can convert into equity shares of the issuing company after a certain amount of time. It's an attractive proposition for investors, and offers low interest rates for businesses looking to raise capital.

Non-convertible debentures

A non-convertible debenture doesn't convert into equity in the issuing company. However, it usually offers a higher interest rate than a convertible debenture, making it a more expensive form of capital for businesses.