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 ready to go public. Especially new establishments. 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 shows the investment amount (principal amount), the interest rate 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
- 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.
- 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.
- 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 list and trade on 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 based on:
1. Security Based Debenture
- Secured Debentures: These are issued against collateral security. The debenture can liquidate the asset in case of borrower default.
- Unsecured Debentures: These are issued by leveraging the goodwill and creditworthiness of a company. These debentures have no collateral. Hence, they are referred to as unsecured debentures.
2. Tenure Based Debenture
- Redeemable Debentures: These have a date of redemption. It is mentioned on the certificate. The borrower must repay before the redemption date.
- Irredeemable Debentures: There is no specific date of redemption for these debentures. The redemption happens only when the issuing company is liquidating.
3. Convertibility Debenture
- Convertible Debenture: 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.
- Fully Convertible Debentures: 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 the 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.
4. Coupon Rate Debenture
- Specific Coupon Rate Debentures: These have a predetermined coupon rate.
- Zero Coupon Rate Debentures: These have no coupon rate.
5. Registration Based Debenture
- Registered Debentures: The issuing company maintains a register and records the details of the debenture holder – name, address, particulars of holding, etc. The transfer of these debentures can happen only through a transfer deed.
- Bearer Debentures: These are transferred by delivery. The issuing company doesn’t keep a record of the debenture holder’s details.
6. Redemption Based Debenture
- Callable Debentures: The issuing company has the right to redeem the debentures before their redemption date. Often such redemptions are done at a premium.
- Puttable Debentures: Here, the debenture holders request the issuing company to settle the loan by principal payment.
- Subordinate Debentures: These debentures holders enjoy priority of repayment in case the issuing company is liquidating.
- Participating Debentures: These are popular amongst venture capitalists. The interest payments are in phases. No interest payment during the initial phase. A lower interest payment during the middle phase. And a higher interest payment during the final phase.
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.
Advantages
- Debentures are debt instruments issued by the company that promises a fixed interest rate on the due date.
- Issuing debentures is one of the most effective ways to raise funds for a company compared to equity or preference shares.
- These instruments are liquid and can be traded on the stock exchange.
- The debenture holders do not have voting rights in the company meetings. Thus, it does not dilute the interest of equity shareholders.
- During inflation, issuing debentures can be advantageous as they offer a fixed interest rate.
- The holders bear minimum risk because interest is payable even in case of loss of the company.
- The company can quickly redeem funds when they have surplus funds.
Disadvantages
- The payment of interest and principal becomes a financial burden for the company in case of no profits.
- The debenture holders are the creditors of the company. They cannot claim profits beyond the interest rate and principal amount.
- During the depression, the company’s profit declines, and it becomes difficult to pay interest.
- The debenture holders have no voting rights. Hence, they do not have control over management decisions.
- During the redemption process of debenture, there is a large amount of cash outflow.
- Default payment has adverse effects on the creditworthiness of the company.
Frequently Asked Questions
Companies issue debentures to raise money for their operating activities or expansion activities.
Debenture holders are individuals or institutions who buy a debenture from the issuing company.
Debentures are issued by companies to raise money to sponsor their growth and operations. Investors buy these debentures and earn regular interest. The debentures can also be issued at a discount or par. Upon the expiry, the issuing company will repay the principal amount.
Banks and other financial institutions use debentures to protect their interests when giving out high-risk loans.
Investors should keep in mind the following risks before investing in debentures: interest rate risk, credit or default risk, and liquidity risk.
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