Debenture bonds are debt instruments that are not secured by collateral. When an investor purchases these bonds, also called unsecured bonds, the company or government agency issuing the bond promises to pay the investor the amount of their investment plus interest at a later date. These bonds are backed by the company's or agency's ability to pay.
Companies issue debenture bonds to raise money, often for capital improvements or other projects. These bonds are usually used to fund projects that are expected to be revenue-producing in the future. A company will usually issue these bonds if it does not want to issue additional stock, which would dilute the price of existing shares.
Investors purchase debenture bonds because they have a fixed rate of return. The return is the interest paid on the bond, which can be paid over time or in a lump sum at the end of the bond's term. These financial instruments can be less risky than stocks, particularly if they are issued by government agencies.
Debenture bonds may be issued at a discount — less than face value — and pay face value at maturity, or they be purchased at face value and pay interest at regular periods. When a bond is issued at a discount, the difference between the purchase price and the face value represents the interest, or return, on the bond. If a bond is purchased at face value, the interest, which is usually paid every six months, represents the investor's return.
Bondholders are considered general creditors. Since these types of bonds are unsecured, investments may be at risk if the company goes bankrupt and cannot pay the interest or maturity value of the bonds. In this case, bondholders get paid only after secured creditors are paid, although they will usually be paid before common stockholders. Subordinated debenture bonds are those bonds that are paid after other, non-subordinated, obligations. Government-issued bonds are generally considered risk-free because the government can raise taxes or print more money in order to meet its obligations.
A debenture bond differs from a collateral trust bond, which is secured by stock, another bond, or some type of collateral. If the company defaults on a collateral trust bond, the bondholder receives the collateral, usually stock or other bond. This is held in trust to secure the bond.