Long Term Borrowing with Debentures
A debenture is a form of borrowing which usually the larger property companies can use. It is one of the more long term forms of borrowing available. A debenture is a tradeable IOU and is quite similar to Gilt edge Securities (gilt edged securities are bonds which are issued by the government). It is also important to define some of the terminology first. In the USA the term debenture normally means unsecured borrowing, but in the UK it usually means borrowing that is secured against assets. It also differs from the bonds and loan stock stock used in the euromarkets as these are also unsecured.
Debentures are suitable for large property companies which have a large property base which can use the properties as security for the debentures. A debenture can run for 30 years and the interest rate can also be fixed so it is also very suitable for companies that are in need of long term finance and are looking for a fixed rate. Since many companies own assets fpr this length of time, it provides a means in which property companies can match the life of their assets with the borrowing length of their loans.
The disadvantage of debentures for the investor however is inflation. Since the return is fixed for 30 years if there is a large amount of inflation. There returns will be eroded over time. As a consequence of this they might require a higher interest rate. The property company however may not be interested in locking itself into a loan for 30 years if it feels that it has a chance of remortgaging in a few years at a lower interest rate.
Due to the reasons mentioned above debentures actually lost popularity in the high inflation years of the 1970's but regained in popularity as inflation has come down in recent times.
The advantages of debentures are (1) long term borrowings (2) These borrowings are often at a low cost compared to unsecured borrowing. For example, lets say company Focusnet wants to raise $300 million. Focusnet agrees to charge some of its real estate as security for the loan. However if the debentures are to be traded on the stock market, usually trustee will be appointed who will hold the security for the benefit of the investors. Often these are will be insurance companies and they will hod the deeds to the properties.
Lets say for example that Focusnet defaults on its payments for the debentures. In this case the trustee can come in and negotiate on behalf of the investors or if need be sell the properties to reapy the investors. if the properties can be sold for a higher value than the toal cost of the loan then the excess can go back to the property owners. This makes the investors fixed charge or secured creditors of Focusnet this is because their claim on Focusnet is a claim on specific properties that focusnet owns.
In the case of debentures lenders usually want an assurance that the property charged produces enough net income that it will cover the interest on the debentures. This ratio is known as income cover.
The income cover will depend on the quality of the buildings. so for example if Focusnet had lower quality buildings the income cover would be higher for this company. On the other hand Focusnet will have to decide what interest rate it is prepared to pay to attract financing to cover their properties. The quality of the companies assets and the reputation of the company will also help determine this. In most cases the yield will have to be higher than government bonds or gilt edged stock as the debenttures will often be viewed a riskier investment.