Debentures are an option often left unexplored by individuals looking to expand their investment portfolio. As with bonds, debentures offer a low-risk means to grow your wealth, acting as an effective counter-weight to more volatile securities, should you have any. As with anything in the investment world, it tends to pay, quite literally, to know the ins and outs of the investment option you are considering. In this article, we will be discussing just that, defining exactly what debentures are and how you might use them to your benefit. Let’s get started.
What are debentures?
In short, debentures are a form of bond that governments and corporations use to raise capital. Where other fundraising methods that acknowledge a debt often use collateral, this is not true for debentures. Instead, investors will receive their return in the form of interest on top of what was invested to begin with. Because of this, debentures tend to be quite a long-term investment, which may make them a poor option for those wanting a quick return.
Due to their long-term nature and lack of collateral, credit rating is one of the most important aspects of debentures. With this being the case, debentures tend to stay in the realm of larger entities with a high credit rating and long history to draw from, for example, governments and large, stable companies. No sensible investor would put their money in a high-risk, volatile entity with a long wait until a return, after all.
How do debentures work?
The second most important question after what is how, at least in finance. Knowing how something works can be instrumental in deciding whether to invest or not.
As mentioned earlier, debentures are most frequently used to raise capital. In the case of governments, they can be a good source of capital for infrastructure projects, roads or public housing being two such examples. For corporate use, debentures can be key to expanding operations, be that funding office expansions, or funding recruitment drives.
More important is what return debentures can provide you and in what form you can expect it. Generally, debentures will benefit the investor by providing interest on their investment. Exactly how will be agreed upon beforehand.
Say you invested in debentures offered by a corporation. Your return, as we’ve mentioned, would take the form of interest on your invested amount. When the time for repayment rolls around, you can choose to receive it in installments or as a lump sum. The interest rate is also subject to change. Depending on your preference, you can choose what kind of interest rate will apply to your debentures, your options being a fixed rate or a variable rate.
Though interest is the preferred method of payment, sometimes you will have the option of converting your debentures into shares. This is heavily dependent on the issuer, however. Some issuers will give you the option, allowing you to choose between monetary repayment, or the owed value in shares. Alternatively, some will only repay in shares, or only repay monetarily. Make sure to check the details to avoid being taken by surprise.
Investing in debentures
Investing in debentures is an ideal option for those wanting a low-risk investment. Ones which are simple and easy to make too. The investment process is pretty much the exact same as any other. Simply fire up your investment platform of choice. Look for any debentures you think might be worthwhile, then invest as you would with any other stock or security. Nice and easy, right?
Of course, though investing in debentures is easy. Their difference to other investment opportunities means different criteria separating good investments from bad. Firstly, to know whether a set of debentures will be worth your time, look at the interest rate. Naturally, your financial situation will determine what interest rates will be worthwhile and which ones will be a wasteful hibernation of your capital.
The second factor, arguably the most important overall, is the issuer’s credit rating. As we’ve mentioned, debentures are not secured against assets. This means that if you make a bad investment, your money is well and truly gone with recompense highly unlikely. Since debentures tend to have lengthy durations, investing in an entity with a poor credit rating is incredibly risky. Instead, you should only seriously entertain those with a strong credit rating, or have enough money to take a risk without impact.
The last point of consideration is the date of repayment, often called the maturity date. This factor is an easy one, as it simply refers to how long you must wait until you see your return. Keep in mind that debentures are a long-term investment though. You’re unlikely to find many under a couple of years.
Exactly what counts as meeting these criteria will be down to your situation and temperament. There is no one size fits all approach. Provided you keep these three factors in mind whilst you examine debentures, your chances of success are much higher than investing haphazardly.
The downsides of debentures
While debentures can be a good investment opportunity, they aren’t without their pitfalls. Keeping to the above factors should provide a ward against bad investments. But, there are two major external variables that could be an issue, namely interest rates and inflation. Interest rates are not static, they can and do change. If you tether yourself to fixed-rate debentures, you run the risk of an increase in interest rates leaving you without an increase in profits. Alternatively, going for a variable interest rate leaves you prone to the inverse risk, where the interest rates fall and your profits take a hit.
Inflation is the second external variable outside your control. Assuming inflation rises quicker than your interest rates, your investment won’t be worth as much once the maturity date rolls around. This could, in a worst-case scenario, mean you take a loss overall.
Should you invest in debentures?
As with anything in the finance industry, pinning down a definitive answer is rather difficult. If you are looking for low-risk investments, don’t mind locking up your money for a few years, and have a keen eye for good opportunities, then debentures might well be for you. Alternatively, if the prospect of freezing your money for an extended time doesn’t appeal to you, or if you’d rather higher risk higher reward investments, then perhaps you’d do better elsewhere. Ultimately, you should check with a financial advisor for professional advice. Whichever you choose, best of luck and happy investing!