Toolbox: Understanding the risks of debentures

With the recent poor performance in equity markets, many investors are attracted to the high rates of interest being offered by debenture and unsecured note issuers, some as high as 15 per cent.

However, some investors mistakenly believe debentures and unsecured notes are the same as fixed term deposits with banks, except with a higher interest rate.

The confusion is not surprising, as nearly all investors are used to receiving interest from their bank deposits. It follows that where they receive interest from a debt security they liken it to a bank deposit.

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What some investors don’t realise is that, unlike fixed-term deposits that carry virtually no risk, debentures come with a high level of risk.

Unfortunately, there’s no such thing as a free lunch with fixed interest securities such as debentures. The market is quite efficient at pricing a risk premium into the return. The variation in the earning rates presently on offer indicates there is a wide range of risk attached to what is being issued by the various finance companies.

It’s important for investors to understand that if one company is offering better returns than another, it isn’t because they are being generous, it is more likely they have a greater risk of not being able to repay investors’ money.

A debenture is a form of debt security, an ‘IOU’ issued by a company. A debt security represents borrowed funds that the borrower has an obligation to repay, and includes such financial instruments tender as bonds and certificates of deposit.

Debentures are typically issued by corporations or finance companies in return for medium to long-term investment of funds for up to five years. Interest can be annual, half-yearly, quarterly, monthly or compounding.

Debentures are secured by the assets of the issuer. Debenture holders’ funds are invested with the borrowing company as secured loans, with the security usually being a form of entitlement to the assets of the borrowing company.

Issued to the general public through a prospectus, debentures are secured by a trust deed that spells out the terms and conditions of the fundraising and the rights of the debenture holders.

Interest is payable on debentures whether the company makes a profit or not.

However, the real worth of any security depends on where the investor ranks in the pecking order of lenders, the quality of assets, and how easy the assets are to sell.

Unsecured notes are similar to debentures, except they are not secured. Generally, they offer higher rates of interest than a debenture of the same maturity but lack the security of a debenture.

Because this form of debt is unsecured, they have more risk than debentures and should therefore provide a higher rate of return.

The risks associated with investing in debentures and unsecured notes include the following:

1. Interest rate risk

The majority of debentures and unsecured notes have a fixed rate of interest and a fixed repayment of capital amount. In this case, where the securities are held to maturity, investors will receive the expected amount, irrespective of interest rate movements. The main risk that fixed-rate debentures and unsecured notes holders are exposed to is the opportunity cost that a better rate of return may be available elsewhere if interest rates were to increase.

2. Credit/default risk

The credit risk is the risk that the investor’s interest and/or capital are not repaid by the borrower. A good credit rating by an independent and reputable credit rating agency gives a measure of confidence for investors.

Unfortunately, the majority of debenture issuers and unsecured notes will not have been rated in this way, which makes it difficult to gauge the financial health of the issuer.

Factors that affect the credit risk include the ranking of the debt in terms of repayment upon liquidation of the company, purposes the investors’ funds will be used for, and financial strength of the company.

3. Liquidity risk

The majority of debentures and unsecured notes do not offer a readily available exit mechanism and as such should be considered a relatively illiquid investment.

Issuers may allow the investor to access their original capital investment at their discretion in special circumstances.

Generally, an illiquidity premium should be factored into the rate of return for investments that are illiquid. This is to compensate the investor for ‘locking up’ their investment for an extended period of time.

Margaret Callinan is research manager atTandem Financial Advice .

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