Join our investing community

Debenture stocks

Discussion in 'Shares' started by Jacque, 14th Aug, 2005.

  1. Jacque

    Jacque Team InvestEd

    Joined:
    16th Jun, 2005
    Posts:
    1,885
    Location:
    Sydney
    What exactly are debenture investments and how do they differ from other offered investments out there in the fixed term world of offerings?
     
  2. Nigel Ward

    Nigel Ward Team InvestEd

    Joined:
    10th Jun, 2005
    Posts:
    1,172
    A "debenture" is simply some form of note or certificate which acknowledges a debt owed by a company to someone. It's a form of "IOU".

    Another sense in which the term debenture is sometimes used is to describe the document under which a company will grant security over its assets to a financier. That document, which these days is typically referred to merely as a "charge" or "charge and mortgage" used to commonly be referred to as a "registered mortgage debenture". The reference to "registered" refers to the fact that for a financier to get effective security over a company it will need to lodge notice of creation of the security with ASIC. ASIC then enters those details in the publically searchable register of charges which it maintains. Notice of a security interest which is entered on the register is thus said to be a "registered" security.

    So enough of the legal mumbo jumbo. What are these debenture things which you see advertised on the TV which you can invest in? They're debentures of the first kind mentioned above. An investor actually loans the company money and will typically receive a fixed interest rate in return.

    One reason debentures are used by finance companies and others to raise funds is that the issue of debentures does not constitute a "managed investment scheme" and thus do not require registration with ASIC, nor does the issuer of the debentures need to hold an Australian Financial Services Licence. All of which makes it much cheaper, quicker and easier from a compliance perspective for the company raising the debenture finance.

    So how do they stack up as investments? Pretty poorly if you ask me.

    One lot of debentures I've seen advertised on the web earned as little as 6.40%pa with the money tied up for 5 years and the interest paid at maturity...what the?! Another I've seen offers somewhat better interest rates of 8% for 1 year notes and almost 10% for 10 year notes, with interest either paid or compounded quarterly. To my mind that's a fairly poor return given the opportunity cost of tying your money up for these periods and the risk involved.

    So what do you get for your money and where's the risk. Well you've lent money to a typically unlisted finance company which will then use that money to on-lend to people at higher interest rates. Commonly for things such as equipment finance. So it sounds a lot like putting your money in a bank. You "invest/deposit" money and get paid interest for it. Conceptually that's right but there is a VERY important difference. Banks are ultimately backed by the Reserve Bank (and the government's power to tax us all to death! :D ) as such putting your money in a Bank is about as risk-free as you're likely to get (and of course the low returns on deposit accounts reflect this low level of risk). In contrast, the issuers of these debentures (or notes as they're often called) will be a relatively small, unlisted company. Also the lending is generally unsecured that is you don't get any security over the company to which you've just loaned money. So if the finance company was to go belly up (i.e. it was mismanaged or it's borrowers couldn't pay the high rates on their tractor loans etc) then you'll just have to line up with all the other unsecured creditors and hope for some crumbs from the liquidator's table... hmmm not too appealing. :(

    So although it seems a lot like putting your money in the bank...but with a b etter better interest rate - in fact the risk profile is VASTLY different.

    Bear in mind that with inflation at 2.5%+ and tax chewing up let's say 2% and opportunity cost of (ooh say last year of 26% for the sharemarket...with arguably less risk if you're investing in blue chip companies with top class businesses) then these fixed rate debentures really return very little. There is NO growth component.

    In my view it has to be a no-brainer that these debentures are not the best investment option around. Anyone else have a different perspective?
     
  3. Jacque

    Jacque Team InvestEd

    Joined:
    16th Jun, 2005
    Posts:
    1,885
    Location:
    Sydney
    Thanks for that detailed answer, Nigel! Was investigating them for some relatives- looks like I might give them a miss at this point :)
     
  4. Nigel Ward

    Nigel Ward Team InvestEd

    Joined:
    10th Jun, 2005
    Posts:
    1,172
    ps. Further to my post, there's an article by respected finance writer Annette Sampson in the weekend SMH 19 August on page 47. The article is well worth reading.

    Here's an extract:

    Another very important point the article makes is that there's nothing to stop a finance company raising far more debt than the founders' equity in the company. The example quoted is a finance company which allegedly has $20m in debentures on issue but only $125k in share capital. Not much skin in the game for the finance company founders!

    Food for thought.