Can you tell your bond from a debenture?

Generally, a bond is a loan secured by specific assets. A debenture is really just a loan backed by a promise to pay and maybe secured by a general claim on the issuer’s remaining assets.

Bond_InvestingWhat is the fundamental difference between a bond and a debenture? Most investors make a distinction between the two, by saying that bonds are secured, and debentures are not. But that’s only roughly true. Debentures, in fact, can be secured, and can on occasion be much safer than bonds.

When a corporation wants to raise capital via a bond or debenture issue, it must first issue a prospectus. In that prospectus, if it pertains to a bond issue, there will be a trust deed. If the prospectus pertains to a debenture issue, there won’t be a trust deed — there will be a trust indenture.

Trust deed is for specific physical property

A bond’s trust deed relates to physical property owned by the corporation that is specifically designated as security to back up the bond.

The three main types of bonds relate to the three main types of physical assets typically pledged to secure a bond. Mortgage bonds pledge real assets, such as a plot of land or a building. Equipment trust bonds pledge the equipment a company owns, such as train cars or trucks or a fleet of aircraft, or a printing press. And collateral trust bonds pledge securities, such as the shares owned in a subsidiary, to back up the bond.

The trust deed (an actual deed to the property, just like the deed to a house) is placed in trust with a trust company, which makes sure all the bond covenants are followed by the issuer to the letter. If any covenants are breached, the trust company, with deed in hand, will seize the pledged property, sell it, and use the money to restore investors, in whole or as best it can.

Of course, if the issuer defaults (breaches one of the bond covenants it made in the prospectus), it depends on the value of the property whether the bond holders will get all their money back. For example, if a $400-million bond issue goes into default, and it’s backed by an office tower worth only $100 million, it’s very possible the bond holders will not get all their money back.

Trust indenture is a general claim on all assets

So that’s what a trust deed does: it pledges physical property to back up a bond.

A trust indenture on a debenture does not pledge specific physical company assets to back it up. Rather, a trust indenture merely places a general claim on all of the company’s assets, physical and non-physical, which have not been otherwise pledged.

Three conclusions can be drawn. First, so-called government bonds aren’t really bonds at all. They’re debentures. If the federal government fails to make an interest payment, for example, its bond holders can’t help themselves to a couple of chairs or a building or something, as no physical assets are specifically set aside to back up any government bond. However, it’s conventional to call them bonds because of the extensive taxing powers bestowed on governments, especially the federal government.

Second, corporate bonds are not necessarily safer than corporate debentures. It depends on the bond and the corporation. For sure, a bond of one corporation ranks senior in liquidation to a debenture of the same corporation. But a debenture of BCE Inc. might well be more secure than a bond issued by, say, Bombardier Inc.

And third, debentures are indeed secured. They’re just not secured by specifically-designated assets. Perhaps, then, when contrasting a bond versus a debenture, it’s best to say that “bonds are secured by specific physical assets; debentures are secured by a general claim on physical and non-physical assets”.

This is an edited version of an article that was originally published for subscribers in the December 15, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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