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.
Debentures have some important features that distinguish them from other financial instruments. These are as follows:
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:
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.
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 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.
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.
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.
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.
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.
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.
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 |
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 |
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.
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:
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 are basically unsecured, whereas bonds carry security in terms of actual assets or collateral.
Convertible debentures are normally convertible into shares of the issuing firm after a stipulated period .
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.
Companies prefer to issue debentures since they can raise funds without diluting the ownership or control and interest paid is tax deductible
Debentures are a source of debt, but the equity shares are a source of equity or ownership in the company with voting rights.
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