Bonds or Debentures

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on November 16, 2021

Bonds or Debentures: Definition

A corporation or company can generally borrow money by issuing debentures or bonds. A debenture or bond is a written acknowledgment by a company or corporation of a loan that is made to it.

It is issued to money lenders under the seal of the corporation. It contains a contract for the repayment of the principal sum at a specified date and the payment of interest at a fixed rate until the principal sum is repaid.

Features of Bonds

If you purchase a bond, you will receive a bond certificate. This certificate spells out the terms of an agreement between the issuer and the investor.

These terms include the denomination or principal of the bond, its maturity date, the stated rate of interest, the interest payment terms, and any other agreements made between the borrower and lenders.

Denomination of the Bond

Individual bonds usually have a denomination of $1,000,  However, in recent
years, $5,000 and $10,000 bonds have become more common.

In this article, we will assume that all bonds are in $1,000 denominations unless otherwise stated.

The denomination, or principal, of a bond, is often referred to as its face value, maturity value, or par value. It is always on this amount that the required interest payment is calculated.

A total bond issue usually contains several hundred or thousands of individual bonds. For example, a $10 million bond might consist of 10,000 individual $1,000 bonds. Investors can purchase as many of these individual bonds as they wish.

After bonds are issued by a large publicly held company, they trade on the New York Bond Exchange. This enables present and potential investors to sell and purchase bonds after their initial issue, just as they do with shares of stock.

Maturity Date

The date that the principal of the bond is to be repaid is called the maturity date. Bonds usually mature within 5 to 30 years from their issue date.

Bonds whose entire principal is due in one payment are called term bonds, and bonds that are payable on various dates are called aerial bonds.

Stated Interest Rate and Interest Payment Dates

Most bonds have a stated interest rate that is part of the bond agreement. This rate is often referred to as the nominal interest rate; it is specified on the bond at the time it is issued. The nominal interest rate does not change over the life of the bond.

The stated rate of interest is fixed by the firm’s management in conjunction with its financial advisers. They attempt to set the rate as close as they can to the market interest rate that exists at the time the bond is issued.

The market rate is the interest rate that the money market establishes through hundreds of individual transactions. The market rate is dependent on factors such as the prevailing interest rates in the economy and the perceived risk of the individual company.

Most bonds pay interest semi-annually (i.e., every 6 months). However, the stated interest rate is an annual rate based on the face value of the bond.

For example, a $1,000, 12% bond that pays interest on 2 January and 1 July will pay interest of $60 ($1,000 x .12 x 6/12) on each of these dates until it matures. In effect, the bond in this example pays 6% interest every 6 months.

Other Agreements

Bondholders are unable to vote for corporate management or otherwise participate in corporate affairs in the way that common shareholders do. As a result, bondholders often insist on written covenants as part of the bond agreement.

These agreements are referred to as bond indentures. While they can take a variety of forms, they usually include restrictions as to dividends, working capital, and the issuance of additional long-term debt.

The purpose of these agreements is to ensure that the borrower will maintain a strong enough financial position to meet the interest and principal payments.

Types of Debentures or Bonds

There are various kinds of debentures that may be issued by a corporation.

Simple or naked debentures or bonds

Simple debentures are those carrying no security as to the payment of interest or repayment of the principal sum. The holders of these are considered insecure, so these are not popular in the present day. Simple debentures are also called naked debentures.

Mortgage debentures or bonds

Mortgage debentures are those secured by a charge on the assets of the corporation, such as plants, machinery, equipment, land, and buildings. Mortgage debentures are of the following two types:

First mortgage debentures

First mortgage debentures are those for which the holders have the first claim on the assets charged.

Second mortgage debentures

Second mortgage debentures are those for which the holders have a second claim on the assets charged.

Bearer debentures or bonds

The amount of bearer debentures is payable to the bearer. They are negotiable instruments and are transferable by mere delivery.

Registered debentures or bonds

The names and addresses of these debenture holders are recorded in the books of the corporation. Transfer of these debentures must be registered in the books of the corporation as in the case of shares. Interest is paid to registered holders.

Redeemable debentures or bonds

These are debentures that are repayable at the end of a specified period. They are issued subject to the condition that the corporation will redeem them on a specified date. These debentures are very common nowadays.

Irredeemable debentures or bonds

These debentures are never repayable during the existence of the corporation. That is to say, they are only repayable on the liquidation of the corporation.

Convertible debentures or bonds

These debentures may be converted into ordinary shares or preference shares of the company. This option is given to the debenture holder for the period mentioned in the conditions of the issue.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.

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