Every company needs funds to run its business operations. Most of the companies raise capital by issuing shares in public. However, it is not feasible for all companies which are not prepared to go public. Especially the companies that have been established recently. There is another common source for obtaining funds which are borrowing. Companies can borrow through bonds and debentures. In this article, we will discuss the various aspects of debenture.
What are Debentures?
The word debenture is derived from the Latin word ‘debere’, which means to borrow or take a loan. It is a debt instrument that may or may not be secured by any collateral. Governments or companies use them for raising capital by borrowing money from the public. In simple words, it is a legal certificate that says how much the investor has invested (principal amount), the interest to be paid and the schedule of payments. The investor receives the principal and interest at the end of maturity.
They are like unsecured loans where the investor has no claim to the company assets if a default occurs. The repayment solely depends on the company creditworthiness of the issuing company. However, before paying stock dividends to its shareholders, the issuing company will fix the debt interest payments. Sometimes, companies also issue them with security, i.e. they have an asset as a mortgage. In liquidation, the company has to preferably pay the creditors by liquidating their assets. Therefore, investors can check the credit ratings of these instruments before investing in them.
When companies have pledged all their assets as collateral elsewhere, they can rely on debentures to raise capital. This is because they have a longer holding period and lower interest rates. Thus, they can be more attractive than other types of long term financing.
What are the Features of a Debenture?
The following are the key features of debenture –
It is a written promise by the issuing company that owes the specified money to the holder.
The face value of debenture is generally the high denomination of Rs.100 or in the multiples of Rs.100
Time of Repayment
It is a debt instrument that the company issues with a maturity date mentioned in the certificate. Basically, it provides the time of repayment of the principal amount and interest on the maturity date.
The holders receive a fixed rate of interest payment periodically, either half-yearly or annually. The rate of interest of this instrument varies depending on the company, the current market conditions and the nature of business operations.
Assurance of repayment
As per the deed, this long term debt instrument carries an assurance of repayment on the specified due date. Also, they can be redeemed at par, premium or discount.
Parties to Debenture
Company – is the entity that borrows money.
Trustee – is the party through which the company deals with the holders. The company creates an agreement between trustees and holders known as ‘Trust Deed’. This deed consists of company obligations, rights of holders, etc.
Debenture Holders – are individuals or parties that provide loans to the company and receive a ‘debenture certificate’ as evidence of participation.
No Voting Rights
The holders are the creditors of the company, and they have no voting rights in the general meetings of the company until the company asks for their opinion in exceptional circumstances.
It needs to be listed with at least one stock exchange.
What are the Types of a Debenture?
A company has the authority to issue different types of debentures that depend on their objectives and requirements. The following are the types of debentures –
Convertible debentures are where the holders have the right to convert their debenture holdings into equity shares of the company. The company specifies the details about the rights of holders, trigger date of conversion, conversion date and other terms and conditions at the time of issue. They are further classified as –
Partly Convertible Debentures
The issuing company can partly convert them into equity shares. The company decides the conversion ratio and the date of conversion when issuing the instrument. The holders enjoy the rights of both creditors and shareholders of the company.
The issuing company can fully convert them into equity shares. The conversion rate and the time of conversion are decided while issuing the instrument. Upon conversion, the holders enjoy the same status as the company shareholders.
Optionally Convertible Debentures
The holder has an option to convert their debt into equity shares or not at a price decided by the issuing company at the time of issue.
Non Convertible Debentures
Non Convertible Debentures are the regular debt instrument that does not allow holders to convert their debt into equity. The interest rate is usually higher for such instruments than their regular counterparts. Thus, these instruments retain their debt character.
Check Out Difference between Bond and Debenture
Advantages and disadvantages of Investing in a Debenture
The following table shows the advantages and disadvantages of investing in a debenture.
|Debentures are debt instruments issued by the company that promises a fixed interest rate on the due date.||The payment of interest and principal becomes a financial burden for the company in case of no profits.|
|Issuing debentures is one of the most effective ways to raise funds for a company compared to equity or preference shares.||The debenture holders are the creditors of the company. They cannot claim profits beyond the interest rate and principal amount.|
|These instruments are liquid and can be traded on the stock exchange.||During the depression, the company’s profit declines, and it becomes difficult to pay interest.|
|The debenture holders do not have voting rights in the company meetings. Thus, it does not dilute the interest of equity shareholders.||The debenture holders have no voting rights. Hence, they do not have control over management decisions.|
|During inflation, issuing debentures can be advantageous as they offer a fixed interest rate.||During the redemption process of debenture, there is a large amount of cash outflow.|
|The holders bear minimum risk because interest is payable even in case of loss of the company.||Default payment has adverse effects on the creditworthiness of the company.|
|The company can quickly redeem funds when they have surplus funds.|