Debentures – How do they work?

Debenture holders can simply hang onto them until maturity, receiving the interest payments and having their capital returned at the end of the period. But it is also possible to trade debentures on a secondary market and it is possible to make either capital gains or capital losses. These debt securities, however, are not considered to carry as much risk as property or share investments.

The capital gains and losses occur in the opposite direction to the movement in interest rates. To illustrate this, let's assume that the government is presently issuing debt securities in the form of a bond with an interest rate of 10 per cent. Tomorrow, it issues a new series of bonds that have an interest rate of 9 per cent. As an investor, you would prefer to be earning 10 per cent rather than 9 per cent and therefore are prepared to pay more than the original capital price to the holder of one of the old bonds. Therefore the holder has not only been paid his capital for the sale of the bond to you but has also gained from the premium you are prepared to pay.

The exact opposite occurs when interest rates rise. Capital losses occur because the holders of existing bonds have to discount their value to be able to sell them.