Debentures and loan stocks

 

Debentures and loan stocks

 Companies often raise long-term interest paying debt, which is known as loan stock, and its holders are long term creditors of the company. Debt ca allowable against corporation capital is attractive to companies because the interest charges on it are allowable against corporation tax, and status quo of shareholder control is also maintained. In addition, we will see later in the course that an increase in the gearing ratio may be beneficial to shareholder by improving their EPS.

 

There are, however limits to the amount a firm will borrow, including restrictions in the articles of association, debenture trust deed and market attitudes. In addition, high interest rates may make high level of borrowing impractical and there may be insufficient security to cover new loans.

Loan stock is often issued at its nominal value. The nominal value represent the amount the company owes and the coupon is based on the nominal value. The coupon rate set depends upon the company, its credit rating and the market conditions when the debt is issued. The market value of the stock will, however fluctuate with changes in interest rates and in the company’s results and prospects.

 

Features of debentures

 A debenture is a multiple loan to the company in the sense that it is contributed by several people as opposed to just one individual. Debentures attract a fixed rate of interest, and debenture holders are creditors, not members of the company. Therefore their interest ranks for payment prior to shareholder’s dividends and must be paid even if the company has made a loss.

 Debentures maybe either redeemable or permanent, a holder of permanent debentures can obtain a return of his original investment by disposing of his holding to a third party, and companies may repurchase permanent debt.

 Most debentures are redeemable, typical issue periods being from 10 to 30 years, often with two redemption dates.

 Debentures tend to be issued in times of low inflation and low interest rates. A redemption will be financed either by cash reserves or by the raising of fresh debt or equity capital. A company and potential investors will compare the finance a company has available with the planned repayment of its debt shown by the repayment dates of its loan stock and debentures.

 Debentures may be issued at par, at a premium or at a discount. Debentures issued at large discount and redeemable at par or above are known as deep discount bonds. They are generally issued at low rates of interest which can be attractive to companies with cash flow problems. However there is a high cost of redemption. The investor maybe attracted by the capital gain at maturity, but you should note that it is taxed as income.

 

 Security and Debentures

 Debentures are generally secured by a trust deed setting out the terms of the contract between the company and the debenture holders. The deed may include security given in the form of,

A specific or fixed charge over particular asset in the form of a mortgage debenture, restricting the alteration and disposal of the asset by the company.

 A general or floating charge on assets, giving a general lien to the debenture holders, but not restricting the company in its utilization of assets.

 The trust deed may also contain provisions for a trustee acting on the behalf of debenture holders to intercede if the terms of the trust deed or Articles of association in relation to the debentures were breached, e.g. Failing to pay the correct amount of interest, or exceeding prearranged borrowing limits. A receiver may be appointed if the company is unable to honor its debts.

 As well as established company may occasionally issue an unsecured or naked debenture. Naked debentures generally have interest rates at least 1% higher than secured debt in order to compensate investors for the additional risk they are bearing.

 

Registration

 Mortgages and debentures must be registered in the company’s own register of charges and with the Registrar of Companies to record their existence.

 

Issue price and conditions for purchase

 Debentures can be issued at a discount and a company may also enter the market and buy up its own debentures without formality.

 

Types of interests

 The great majority of debentures are issued at fixed rates of interest. There are two possible variations and these are,

 

1.    Floating rates

This issuer will be able to vary the interest paid. For the issuing company, floating rates afford protection in periods of volatile interest rates since it will benefit when rates fall. Investors benefit, since they should obtain a fair return whatever happens to interest rates generally.

The market value of the debentures depends on the coupon rate of interest compared to general market value. The value should remain stable since the interest payable on the debentures will follow that of the market.

 

2.     Zero coupon

There are debentures which are issued with no rate of interest attached. Instead they are issued at a discount. Thus there is an implied rate of interest in the level of the discount. The advantage to the borrower is that there is no cash outlay until redemption. For the lender, there maybe tax advantages in not receiving income in the short term.

 

 Return for investors

 To determine whether a potential investor will receive a certain rate of return by investing in a particular debenture, we need to calculate the net present value of all cash flows involved