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"DEBENTURES"Bonds can be useful for adding a conservative component to an investment portfolio to balance out stocks or other high-risk securities. Debentures are a specific type of bond that government entities or corporations can use to raise capital. While all debentures are bonds, not all bonds are debentures. The biggest difference between the two has to do with how they’re collateralized. If you’re considering investing in debentures, it’s helpful to understand how they work and how they compare to traditional bonds. Sorting through all the debt securities options that are out there can be confusing; a financial advisor can help you find which ones work best for your financial plan.

What Is a Debenture?

A debenture is a type of bond that is not secured by any sort of collateral. Governments and corporations can use debentures as a capital-raising tool in lieu of taking out traditional loans. Debenture investors contribute necessary funds with the agreement that the money they’re putting up will be repaid later with interest.

Since there’s no collateral, investors must assume that the government or company issued the debenture can and will pay them back when the time comes. In effect, investors are placing their good faith in the debenture issuer. For that reason, debentures may be more commonly associated with companies or government entities that have strong credit profiles.

How Debentures Work

Debentures are often issued when a corporation or government needs to raise capital for a specific purpose. For example, a city government may need funds to move ahead with road maintenance or construction projects while a corporation may require capital to complete an expansion project. In these types of scenarios, debentures can act as a form of long-term financing.

When a debenture is issued, it can offer a floating or fixed-interest coupon rate for investors. In the case of corporate debentures, interest payments may be paid ahead of shareholder dividends. When it’s time to repay the principal on debenture investments, issuers can choose between lump-sum payments or installments.

In some instances, companies may allow investors to convert their debenture into shares of stock. Whether this is optional or required depends on the terms of the debenture. Convertible debentures may be attractive to investors who are interested in eventually owning an equity stake in the company.

Debentures can be an attractive option for raising capital when a corporation or government would prefer not to use existing assets as security for traditional bonds. Companies may also rely on debentures to raise capital if they’ve already pledged all available assets as collateral elsewhere. Because they often have longer repayment windows and lower interest rates, debentures may be more attractive than other types of long-term financing.

Debentures vs. Traditional Bonds

Debenture price graphAgain, all debentures are bonds, but not all bonds are debentures. While traditional bonds are collateralized, meaning there’s some type of security behind them, debentures are backed only by the full faith and credit of the entity that issues them. Corporations and governments can issue both bonds and debentures. With bonds, the investor has the promise of receiving repayment on their principal, along with interest payments. But in case the bond issuer defaults on that promise, there’s underlying collateral that could be used to repay what’s owed to investors.

Generally speaking, bonds and debentures are safer investments than individual stocks or mutual funds. That’s because bonds can offer a stable or guaranteed rate of return over time. Debentures can be riskier than bonds for investors because there is no collateral in place, though not all debentures are the same in that regard. U.S. Treasury bonds and U.S. Treasury bills are both debentures, for example, though since they’re issued by the government, there’s very little risk of investors not being repaid.

How to Invest in Debentures

Investing in debentures is something you may consider if you’re interested in diversifying your portfolio and you already have traditional bond holdings. It’s possible to invest in debentures through an online brokerage account, just like you would with other bonds, stocks and securities.

What’s important is understanding how to evaluate and compare on debenture to another to find the right one for your investment goals and needs. When looking at debenture opportunities, pay attention to the following:

  • Coupon rate. The coupon rate or interest represents what you’ll earn for investing in the debenture. This rate can be floating or fixed and it’s important to understand how your rate of return will be calculated.
  • Maturity date. A debenture’s maturity date refers to when the issuer must repay its investors. This is important to know if you’re including debentures in a long-term investment strategy.
  • Credit rating. Creditworthiness is important for evaluating any bond issuer but it may be even more so with unsecured debentures. The stronger the debenture issuer’s credit rating is, the more the odds of default decrease.

The goal is to choose a debenture that fits your investment style and goals. Also, keep in mind that corporate and government debentures aren’t identical when making comparisons.

And consider how much of your portfolio you want to allocate to debentures, depending on your age and risk tolerance. Putting too much of your money into conservative investments at a younger age could shrink your overall return portfolio, while you might prefer to go the safer route if you’re closer to retirement.

Know the Risks of Debentures

Debentures are generally lower-risk investments than stocks but they aren’t entirely risk-free. There are some specific factors to consider when evaluating whether they’re a good fit.

For example, you may be subject to interest rate risk with fixed-rate debentures. If interest rates rise after you invest in a debenture, you may miss out on higher yields if you’re locked in at a lower rate. Likewise, floating rate debentures could yield lower rates of return if the benchmark rate they track drops.

Credit risk is also something to consider, though again, companies or governments that issue debentures typically have stronger credit ratings. But on the off chance that a government defaults or a company goes under, you could lose money on a debenture investment.

Finally, consider how inflation and shifting prices for consumer goods could affect debentures. If inflation is on the rise and it outpaces the interest generated by debentures, you could find yourself struggling to break even or worse, posting a negative return.

The Bottom Line

Blocks marked as various types of investable securities

Debentures allow companies and governments to raise capital for the long-term without offering assets as collateral. You may choose to invest in debentures as a means of increasing portfolio diversification. It’s important to compare debentures carefully, as some carry more risk than others. In addition, it’s important to compare and contrast debt instruments in general with equity alternatives.

Tips for Investing

  • If you don’t have an online brokerage account yet, take time to compare options before opening one. Specifically, pay attention to the types of accounts you can open, the range of investment options available, minimum investment requirements and the fees a brokerage charges. If you also plan to trade stocks, exchange-traded funds or other investments while purchasing debentures, you may want to choose a brokerage that charges $0 commission fees.
  • Consider talking to a financial advisor about whether debentures may be a good fit for your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. You’ll just need to answer a few brief questions to get your personalized recommendations online. If you’re ready, get started now.

Photo credit: ©iStock.com/lakshmiprasad S, ©iStock.com/Jira Pliankharom, ©iStock.com/William_Potter

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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