The term "debentures" is something you might see in financial statements, offering documents or research reports. Learning how debentures work can help you explain both the opportunities and the risks to your clients.
In this article, Wealth Professional Canada will explore what debentures are and which risks you need to watch for when recommending them to your clients. You can also find the latest news on debentures when you scroll to the bottom of the page!
A debenture is a form of long-term debt that a company or government issues to raise money without pledging specific assets as collateral. Instead of a traditional secured loan from a bank, the issuer borrows from investors through a debenture.
The issuer then promises to pay interest and repay the principal at a future date. You can think of a debenture as a written agreement between the issuer and the creditor. The debenture certificate records:
Debentures are often structured as medium to long-term obligations. Since they are unsecured, issuers tend to offer a higher interest rate than they would for a secured loan or secured bond. That higher coupon compensates investors for accepting greater credit risk.
Some debentures are listed and traded on stock exchanges. This helps make them marketable, since the original holder can sell to another investor rather than hold the debenture until maturity.
Want to learn more about debentures? Watch this video:
Top Canadian financial advisors can use debentures to build income strategies that match clients' goals and comfort with risk.
The answer depends on your client's goals, risk tolerance, and time horizon, as well as the specific issuer and debenture terms. For some investors, debentures can be a useful source of income and a way to sit higher in the capital structure than shareholders.
For others, the lack of collateral and the potential price volatility might be concerns. From your clients' side, a debenture can be seen as good if:
On the other hand, a debenture can be seen as bad for your clients if:
Here are six reasons why your clients might consider investing in debentures:
Let's discuss them one by one:
Debentures usually pay interest at a fixed rate on a set schedule. This predictable stream of payments can appeal to clients who value regular income, such as those approaching retirement.
The same is true for those who want a stable component within a diversified portfolio.
Because debentures are unsecured, issuers tend to offer a higher interest rate than they would on secured loans or secured bonds.
For investors who are comfortable with the additional risk, this can mean a higher expected return compared with certain other debt from the same borrower.
Debenture holders are creditors of the company, not owners. Interest on debentures is generally paid before dividends are declared for shareholders. In a bankruptcy or liquidation, debentures are repaid after secured debt but still stand ahead of common and preferred shares.
This priority can provide more protection than owning shares if the issuer runs into serious financial trouble.
Unlike many traditional bank loans, debentures are often designed to be transferable. The holder can sell the debenture to another investor, either through an exchange or in an over-the-counter market, if trading exists.
This quality can be helpful for clients who want the option to exit before maturity, even though liquidity is not guaranteed.
Some debentures are convertible. This means the holder has the right to convert the debt into shares of the issuing company under terms defined in the debenture certificate. In some cases, only part of the debenture can be converted, with the remainder repaid in cash.
For your clients, a convertible debenture can combine features of debt and equity. They receive interest payments like a bondholder while retaining the option to convert into shares if the company performs well and the share price rises.
Including debentures from different issuers and sectors can help diversify the fixed income portion of your clients' portfolios. While you must always consider the specific risks, debentures can sit alongside other instruments such as:
Even when a debenture appears attractive, your clients are exposed to several types of risk. Here are four of them:
Debentures are usually unsecured obligations. The issuer does not pledge specific assets as collateral. Repayment depends on the issuer's financial strength and future cash flows.
If the issuer's business weakens, it might struggle to make interest payments or repay the principal at maturity. In more severe cases, this can lead to a restructuring or default where investors might lose part or even all of their capital.
Like other fixed income instruments, debenture prices respond to changes in interest rates. When market interest rates rise, the prices of outstanding debentures with lower coupons usually decline. When rates fall, those prices generally rise.
The degree of sensitivity depends on the debenture's term to maturity and coupon structure. Long-dated debentures and those with lower coupons tend to experience larger price swings when interest rates change.
Not all debentures trade actively. Debentures from smaller or mid-sized issuers can see limited trading volumes and wider bid-ask spreads. During periods of market stress or when concerns arise about a specific sector or issuer, liquidity can dry up even further.
For your clients, this liquidity risk means it might be hard to sell a debenture quickly at a fair price. They might have to accept a steep discount to exit or hold longer than they originally planned.
Most debentures pay a fixed nominal interest rate. The real return that your clients achieve depends on inflation over the life of the debenture. If inflation runs higher than expected for a prolonged period, the fixed coupon stream loses purchasing power.
The lump sum that your clients receive at maturity will also be worth less in real terms, even if the issuer never misses a payment.
Debentures and shares serve different purposes for both issuers and investors. Whether one is better than the other depends on what your clients are trying to achieve.
From a balance sheet perspective, debentures represent long-term debt and appear as liabilities. On the other hand, shares represent ownership, and their value appears in shareholders' equity.
Debenture holders are creditors. They receive interest payments and stand ahead of shareholders in the capital structure. Their upside is generally limited to the contracted coupon and repayment of principal.
Shareholders are owners. They can benefit from dividends and increases in share price, but they stand last in line if the company fails.
Debentures might be better for your clients when:
Shares might be better when:
Convertible debentures sit somewhere between these two concepts. They start as debt with interest payments but offer the possibility of becoming equity if converted into shares. This structure can be attractive to clients who want income today with some chance of sharing in future equity growth.
Find out how investors and companies can benefit from convertible debentures under Canadian law when you read this article.
No investment is completely safe, and debentures are no exception. Safety depends on both the issuer and how the debenture compares with other instruments in the capital structure.
On one hand, debentures stand ahead of common and preferred shares in the event of bankruptcy or liquidation. Interest payments are also generally made before dividends. This higher priority can offer more protection than owning shares in the same issuer.
On the other hand, debentures sit behind secured creditors and certain other priority claims. In a severe downside scenario, the absence of collateral and the presence of more senior debt can limit what is left for debenture holders.
Debentures occupy an essential space between traditional secured debt and equity. When you look at a debenture, you're examining more than just a coupon and a maturity date. You're considering the issuer's overall strength and how the debenture ranks relative to other obligations.
You're also weighing these elements against your clients' income needs, time horizons, and comfort with risk. When used thoughtfully, debentures can provide regular income, some protection ahead of shareholders and, in the case of convertible structures, a potential path into equity.
When your clients understand how debentures work, it becomes easier for them to see where these investments fit in their portfolios. They will also see how debentures can support their long-term financial goals.
Looking to strengthen your clients' portfolios? Read this guide to learn why investing in BMO mutual funds could be the key to achieving their investment goals
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