A significant risk for a bondholder is the potential for the bond issuer to default. When a bond issuer defaults, an investor's return is less than the original, promised return. The more likely it is that the bond issuer will default, the higher the risk premium, and the higher the bond's yield to maturity. Due to the default risk, a bond issuer may pledge collateral to secure the bond. The issuer of a debenture offers no such collateral.
A debenture bond represents money a company has borrowed from the general public, who become creditors of the company. When issuing bonds, a company promises to repay the principal amount it borrows on an agreed-to date, and at a particular rate of interest paid at specified intervals. The bond's face rate is the interest rate the company pays to the bondholders, which is determined by the bond’s face value. Companies usually set this fixed interest rate close to the prevailing market interest rate, which is the rate paid on similar bonds with equivalent risk. If the market interest rate differs from the face interest rate, the bond’s issue price will differ from the bond’s face value. The bond is sold at a discount if the bond’s issue price is less than its face value. The bond is sold at a premium if the bond’s issue price is greater than its face value.
A company may issue convertible debentures or nonconvertible debentures. The issuing company can exchange a convertible debenture to a predetermined quantity of stock or other security after a specific period of time. A company often issues this security at an interest rate that is lower than that of a nonconvertible debenture due to the conversion option, which means the value of the debenture will rise as the stock rises. The conversion may be mandatory or at the option of the debenture holder.
A company cannot convert nonconvertible debentures to stock. As a result, a company issues a nonconvertible debenture with a higher interest rate than a convertible debenture. There are two types of nonconvertible debentures: secured and unsecured. A company's assets back a secured nonconvertible debenture. If the company defaults, the investor has a claim against the company's liquidated assets.
Use of Debenture Bonds
The holder of a debenture bond is a general creditor of the bond issuer. The claims of general creditors are protected by property that is not pledged as security for other debt. The credit history of the issuer and the nature of the company's assets determine if a company might issue debenture bonds rather than secured bonds. For example, ExxonMobil and Microsoft might issue debenture bonds because of the low risk of default. Companies with poor credit might also issue debenture bonds if the company has previously pledged its assets as security for other debt. In this case, the interest paid to the bondholder will be relatively high to compensate for the risk of default.
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