“Debenture” is one of those terms that we come across a lot in finance, and yet many people still do not know what it means. This is partly because the term actually has a different meaning in different places. In the UK, for example, debentures are used by lenders to ensure that they receive full repayment even if borrowers end up defaulting. This is done by securing the loan against certain assets belonging to the borrower. In the US, however, the term has almost the entirely opposite definition, as it is a totally unsecured loan. To understand these differences, as well as other key information about what debentures are and how they are used, here is everything you need to know!
What is a debenture?A debenture in the UK is an agreement between a borrower and a lender which essentially grants the lender ownership of the borrower’s assets if they default on their loan. The lender is usually a bank or another financing company, and in the UK, the borrower is usually a business who needs capital. In a debenture, the borrower agrees to repay the loan in x number of £y installments for z months. If they fail to do so, the lender can then use the debenture to take control of assets in lieu of payment.
What are the different types of debentures?In terms of UK debentures, there are two main types of debentures which are agreed between lenders and borrowers: The first is known as a fixed charge. This means that the loan is secured with a physical asset like the company’s property or inventory. If the borrower defaults on their payments, the lender would repossess this property and could then sell it to recover their money. In the case of a fixed charge agreement, the borrower cannot sell any of these assets without first getting the permission of the lender. The second type of UK debenture is called a floating charge. As can be guessed from its name, a floating charge secures a loan with less-permanent assets than a fixed charge. Rather than property and inventory, the loan is instead secured with shares, copyrights, intellectual property, and raw manufacturing materials. Unlike with a fixed charge, a borrower can sell these assets without getting permission of the lender, but if they default on their loan repayments, these assets can become fixed charges instead.
How do debentures work in practice?In simple terms, debentures come into effect through an indenture agreement between a borrower and a lender. The indenture includes the loan amount, maturity date, interest rates and the details of fixed/floating charges. The borrower then receives the loan and is then expected to make the repayments as agreed. If they don’t, their assets may be forfeit.
A simple example of a debenture in action:Jeff Bezos finds himself a little cash-strapped, so Amazon applies for a loan of £100,000 which must be paid back on January 1st 2030. The lender agrees to 7% annual interest, which must be paid on August 1st each year. A debenture is put in place that if Amazon defaults on those yearly payments, the lender can start selling off the agreed assets to get their money back.
What are the advantages of debentures?There are various advantages of debentures for both the borrower and the lender, so let’s look at them one by one:
Advantages for the borrower
- The borrower is able to secure the finances they need for their company.
- There are no restrictions about the size of debenture secured loans.
Advantages for the lender
- Debentures usually pay far higher interest rates than other types of loans.
- Convertible debentures can be converted into shares or other types of financial assets.
- Debentures can be transferred to other financial entities so the lender doesn’t need to keep any debenture that they don’t want.
What are the disadvantages of debentures?
Disadvantages for the borrower
- The interest payments put the borrower in a financial bind with the only way out either completing the terms of the agreement or defaulting.
- With default can come serious losses depending on the terms of the agreement. Many borrowers end up losing far more than the original value of the loan.
Disadvantages for the lender
- Increases in national interest rates can put the lender at risk of losing money because debentures have fixed interest rates.
- These fixed interest rates may also not correspond with national inflation rates so the lender could end up shortchanged.