Bonds can be issued on either an unsecured or secured (asset-backed) basis. Debentures, subordinated debentures, and income bonds form the major categories of unsecured bonds, whereas mortgage bonds represent the most common type of secured long-term debt instrument.
The word debenture usually applies to the unsecured bonds of a corporation. Because debentures are not secured by any specific company property, the debenture holder becomes a general creditor of the firm in the event of company liquidation. Therefore, investors look to the earning power of the firm as their primary security. Although the bonds are unsecured, debenture holders are afforded some protection by the restrictions imposed in the bond indenture, particularly any negative-pledge clause, which precludes the corporation from pledging any of its assets (not already pledged) to other creditors.
This provision safeguards the investor in that the borrowerâ€™s assets will not be additionally restricted. Because debenture holders must look to the general credit of the borrower to meet principal and interest payments, typically only well established and creditworthy companies are able to issue debentures.
Subordinated debentures represent unsecured debt with a claim to assets that ranks behind all debt senior to these debentures. In the event of liquidation, subordinated debenture holders usually receive settlement only if all senior creditors are paid the full amount owed them. These subordinated debenture holders would still rank ahead of preferred and common stock holders in the event of liquidation. The existence of subordinated debt may work to the advantage of senior bondholders because senior holders are able to assume the claims of the subordinated holders. To illustrate, suppose that a corporation is liquidated for $600,000. It had $400,000 in straight debenture outstanding, $400,000 in subordinated debentures outstanding, and $400,000 in obligations owed to general creditors. One might suppose that the straight debenture holders and the general creditors would have an equal and prior claim in liquidation â€“ that each would receive $300,000. The fact (of law) is that the straight debenture holders are entitled to use the subordinated debenture holdersâ€™ claims, giving them $800,000 in total claims for purposes of determining a partial repayment. As a result they are entitled to two-thirds ($800,000/$1,200,000) of the liquidating value, or $400,000, whereas the general creditors are entitled to only one-third ($400,000/$1,200,000) of the liquidating value, or $200,000.
Because of the nature of the claim, a subordinated debenture issue has to- provide a yield significantly higher than does a regular debenture issue in order to be attractive to investors. Frequently, subordinated debentures are convertible into common stock. Therefore, this added option feature may allow the convertible subordinated debenture to sell at a yield that is actually less than what the company would have to pay on an ordinary debenture.
A company is obligated to pay interest on an income bond only when the interest is earned. There may be a cumulative feature where unpaid interest in particular year accumulates. If the company does generate earnings in the future, it will have to pay the cumulative interest to the extent that earnings permit.