A debenture is a long-term debt instrument of any corporation issued to borrow money from the public or other financial institutions. The company undertakes an obligation at the time of issuance to pay interest at a fixed rate for some period and the repayment of the principal amount at the time of maturity. Debentures are unlike loans tied to assets because they are not secured by any physical assets or collateral. This has made debentures one of the favorite ways of raising capital, which does not dilute ownership. They are substantially used by the corporate world, and companies need an efficient way to raise capital without diluting ownership.
Key Features of Debentures
Debentures have some important features that distinguish them from other financial instruments. These are as follows:
- Fixed interest payments: The interest rate on the debenture takes the form of a known rate of interest, called the “coupon rate.” It is paid periodically, usually annually or semi-annually. The interest payment is an absolute obligation of the issuing company to pay, irrespective of the financial performance of the issuing firm.
- No problem of dilution: The debenture holder is a creditor rather than the owner. Hence, the debenture issues do not bring about dilution or dilute the control or ownership stakes of existing shareholders, as in the case of issuing equity shares.
- Maturity period: Debentures carry a specific term or period of maturity. At the maturity period, the holder is repaid the principal amount. The maturity period varies from short-term under 5 years to long-term for more than 10 years.
- Secured vs. Unsecured: Most of the debentures are issued on an unsecured basis, but some are made to be secured ones, supported by the company’s assets, which provide additional security in case of default to the investors.
- Convertibility: Some are convertible, whereby they are convertible into equity shares either at a stipulated time or under certain circumstances.
- Priority in Liquidation: Debenture holders are paid before shareholders but after secured creditors in case of liquidation.
Different Types of Debentures
As you would imagine, debentures come in a variety of different forms to meet the needs of investors and company strategy. The most basic types are as follows:
Secured Debentures
These are secured by the assets of the company so that, in case of default by the company, the debenture holder is paid using such assets. In case of default, secured debenture holders have a claim on the assets associated with the debenture.
Unsecured Debentures
Also known as “naked debentures,” they are not supported by any collateral. The payment of such debentures depends upon the creditworthiness of the issuing firm. They are riskier than secured debentures, but their paybacks are usually higher.
Convertible Debentures
Convertible debentures can be converted into equity shares of the issuer company after a specified period. Such debentures are quite tempting to investors who look at the future as owning some amount of the company.
NCDs
The word NCD defines itself. That is, NCDs are non-convertible. In other words, these debentures cannot be converted into shares. These debentures are purely debt instruments, and the company has to pay back the principal and interest on maturity.
Redeemable Debentures
The corporation has to repay, on a known date, the principal amount of redeemable debentures. Its redemption is always at par or a premium or at a discount, which would have been agreed upon before issuance.
Irredeemable Debentures (Perpetual Debentures)
These debentures do not carry any maturity date, so the principal need not be returned by the company. The interest keeps flowing to the debenture holders perpetually so long as the company is solvent.
Registered Debentures
They are registered in the company’s register, and further transfer can only take place upon registration with the company. These offer additional safety to the investors.
Bearer Debentures
These are non-registered and can be transferred simply by delivery. Payments of interest are payable to the bearer, making these types of debentures more flexible but more dangerous.
Difference Between Debentures and Shares
Debentures and shares are both methods of raising capital but differ fundamentally in structure and purpose:
| Aspect | Debentures | Shares |
| Nature | Debt instrument | Equity instrument |
| Ownership | No ownership stake | Ownership stake in the company |
| Returns | Fixed interest payments | Variable dividends based on profits |
| Risk | Lower risk, fixed returns | Higher risk, returns depend on company performance |
| Repayment | Principal repaid at maturity | No repayment, represents ownership |
| Voting Rights | No voting rights | Voting rights in company decisions |
Differences Between Debentures and Bonds
While both debentures and bonds are forms of debt instruments, they have subtle differences:
| Aspect | Debentures | Bonds |
| Security | Usually unsecured | Typically secured against assets |
| Issuer | Mainly issued by private companies | Issued by governments, municipalities, and corporations |
| Risk Level | Higher risk due to lack of security | Lower risk due to asset backing |
| Purpose | Used primarily by companies to raise capital | Governments issue bonds for infrastructure and public projects |
What are the Advantages of Debentures?
Debentures are debt securities issued by a corporate entity to raise funds. It provides a fixed income stream to an investor and tends to be very attractive for those in search of predictable returns. As with any investment, debentures have their pros and cons.
- Lower Cost of Capital: Debentures have much lower interest rates compared with bank loans, and the cost is, therefore, much cheaper when financed.
- Preservation of Control: Since debenture holders are creditors rather than shareholders. The issuance of debentures permits companies to raise funds without diluting ownership or control.
- Fixed Interest Payments: The company offers fixed and predictable interest payments, which attract risk-averse investors.
- Tax Deduction: The amount of interest paid by the issuing company on debentures is tax-deductible.
- Flexibility: Companies may issue debentures with flexible features like the option of being convertible into shares to attract investors.
What are the Disadvantages of Debentures?
The apparent disadvantage of debentures is a fixed-income stream. The major drawbacks include the fixed interest rate, which becomes unattractive if market interest rates rise. Debentures have some benefits, there are a few drawbacks as well:
- Interest Liability: Even when the company earns nothing, it has to pay interest. Defaulting on obligations results in bankruptcy or a financial crisis.
- No Shareholding for Investors: Debenture holders do not have a vote or voice in the affairs of the firm and may not attract investors seeking greater involvement.
- Risk of Default: Generally, unsecured debentures are relatively riskier for investors as they do not have specific assets behind them.
- Repayment of Principal: This sum upon maturity can be sensitive to the financial condition of a company if mishandled.
- Market Risks: The market rate of interest can determine fluctuations in the debentures’ value and subsequently affect its resale.
Conclusion
The role of debentures in a company’s financial strategy is to provide one means of raising debt without diluting ownership. To an investor, it provides a stable return at fixed interest rates with lower risk as compared to equity. Here, the parties consider the pros and cons of both of them as the direction depends on market conditions and interest rates as well as the financial strength of the issuer.
Debentures FAQs
How are debentures and bonds different from one another?
Debentures are basically unsecured, whereas bonds carry security in terms of actual assets or collateral.
Can debentures be converted into equities?
Convertible debentures are normally convertible into shares of the issuing firm after a stipulated period .
What happens if a company fails to pay its debentures?
If a company defaults, its debenture holders can file a case for the return of their investment. The secured debenture holders may be permitted to liquidate the collateral mortgaged with the issue of debentures.
What are the reasons for issuing debentures over shares?
Companies prefer to issue debentures since they can raise funds without diluting the ownership or control and interest paid is tax deductible
What is the difference between equity shares vs debentures?
Debentures are a source of debt, but the equity shares are a source of equity or ownership in the company with voting rights.
