Unsecured debentures explained
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It’s rare to come across unsecured debentures in the UK. But if you do hear the term it's likely to be in reference to a form of loan agreement that isn't supported or secured against collateral. Also known as ‘naked debentures’ this means that a borrowers’ assets – such as property or equipment – are not put up as security against a loan. Instead, the debenture agreement relies on the creditworthiness and reputation of the borrower.
How do unsecured debentures work?
Unsecured debentures are agreements that outline the terms and conditions of a loan. Because there is no specific asset used as security, the interest rates associated are often higher.
Because of this, if a borrower defaults then the lender does not have an immediate right to the assets and will have to wait in turn with other creditors. With unsecured borrowing, lenders will usually mitigate risk by requiring a personal guarantee.
Example of an unsecured debenture
A successful high street retailer might wish to raise capital to fund further growth. If it has a very strong credit standing (good cash flow and no default record), it will be viewed as a safer risk by a bank or other financial institution. In which case it might be eligible for an unsecured loan which requires a debenture, meaning its premises and other assets are not secured against the loan.
How does a secured debenture differ?
With a secured debenture, borrowers must put up assets as collateral in case they are unable to pay their debts. If a borrower defaults, lenders have first claim on the assets.
The assets fall into two categories – fixed charge and floating charge – with lenders seeking one or both. Fixed charge includes property and building fixtures, while floating charge relates to assets such as stock and business equipment. Holders of secured debentures have priority over holders of unsecured debentures, who must join the queue with other creditors to make a claim.
More on loan security types:
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