Debenture vs. Bond: What Is the Difference and Are There Hidden Risks?
There is often some confusion when it comes to debentures and bonds, but it’s useful for both business owners and investors to know the difference.
Put simply, bonds are a common way for companies to borrow money from investors for growth, while a debenture is a specific type of bond that offers a lender more security on the loan.
Here, insolvency practitioners Hudson Weir outlines the differences in more detail and highlights the potential risks involved.
What is a debenture?
As a business owner, there may be times when you need to borrow money to fund the growth and development of your company and its future.
A debenture is a type of bond and written loan agreement that is secured by assets or property of the issuer (the borrower). It aims to provide the lender with more security over the borrower’s assets should they fail to make repayments.
Debentures are registered with Companies House within 21 days of being taken out and are usually used by banks, factoring companies, invoice discounters or private lenders for additional reassurance over the money they have loaned out. Equally, business directors who lend money to their own company can take out debentures to secure the loan.
Within the document, borrowers should expect to find the specifics of the terms such as the total amount borrowed, the interest rate applied to the fixed or variable loan, the amount due to be repaid and the time frame in which it is due.
In addition to this, business owners should be aware that lenders are able to attach charges to the loan to provide them with further security. These can be either fixed or floating depending on the terms of the debenture and mean that the lender will be prioritised over unsecured creditors.
What are the risks involved with a debenture?
There are a number of advantages of debentures, not least because they provide funding with typically lower interest rates than unsecured loans. As such, they can be a cost-effective way for businesses to borrow money to increase company growth and development. However, there are some risks that need to be watched out for.
While lenders do not generally get involved in the day-to-day trading of a business they have loaned to, business owners and company directors should be aware that debentures still give lenders a lot of control over the company. For example, the lender has the authority to appoint an administrator to take control if the company defaults on the loan.
One of the biggest risks of a debenture concerns the mandatory interest rates outlined in the document. If your company falls into financial difficulty, the interest alone attached to a debenture could further add to the company losses.
If your business is struggling to make repayments or if you have defaulted on the loan, the lender also has the right to block you from appointing your own administrator and can also prevent you from going into liquidation.
The administrator will then pass over assets caught by the debenture to the lender, or will sell the assets on their behalf for an arranged fee.
Business owners who are considering taking out a loan with a debenture should be mindful that assets can fall into a fixed or floating charge category, with a fixed charge relating to freehold or leasehold property, plant and machinery that are fixed to the floor and book debts, while a floating charge refers to movable assets such as equipment, furniture and computers.
Any business owners or directors that are struggling to make repayments on their loan but have given the lender a personal guarantee are able to use the company assets first to recover the loan.
What is a bond?
Put simply, a bond is an IOU and is the most common type of debt instrument typically used by private businesses, corporations and governments. Lenders (usually investors) who buy such bonds are loaning money to the issuer for a fixed period of time, with the bond being repaid at the end of it.
There are two payments made by the borrower to the bondholder. One is made when the bond ‘matures’, which is known as the final payment. On top of this there are smaller payments (coupons) which are a percentage of the final payment.
What are the risks involved with a bond?
While debentures carry a number of risks for the borrower, bonds are considered to be relatively safe, with a guaranteed rate of return and generally little perceived default risk for the investor. Some investors are even encouraged to keep a percentage of their assets in bonds until they reach retirement.
While it could be said that debentures provide more security for the lender, bonds are bought on the assumption that the borrower is trustworthy or stable enough to pay it back, with some degree of return for the investor.
Despite this, there are always some risks attached to investing. For example, it is still possible that the issuer may fail to make scheduled repayments to the lender, and therefore default on the bonds.
While a debenture can carry fixed or floating charges, bonds don’t have this degree of security attached to them. As such, if a company falls into financial difficulty the investor could lose out on the whole amount invested. Some companies will also have higher priority debts (secured debts, for example) and may be obliged to make repayments elsewhere first.
Debentures vs Bonds
Debentures are secured loan agreements that provide the lender with peace of mind that their money will be returned to them. However, bonds can be seen as a way for investors to make some return on their money, with some risk to the lender due to the IOU being based on a degree of trust.
Before agreeing to a debenture or selling bonds, companies should explore the options available to them and understand the potential risks to the business before going forward.