Companies require access to capital to fund various business operations, undertake new projects, and invest in growth. While many companies may issue shares to the public to raise capital, this option may not be feasible for newly established ventures. In such cases, these companies often resort to issuing debentures instead. This article outlines what are debentures, the various types of debentures issued, benefits of debentures, and the risks associated with this type of debt instrument.
What is the Meaning of Debentures?
Debentures are long-term debt instruments that may or may not be backed by collateral. They are backed by the creditworthiness of the issuer. Both companies and governments can issue debentures to raise funds. Debentures are essentially legal contracts where the issuer promises to pay fixed interest at regular intervals and repay the principal invested sum after a specified period. Therefore, a debenture certificate outlines the principal amount, interest payable, and corresponding payment schedules.
What Are the Key Features of Debentures?
- Written promise: A debenture is issued as a written promise issued by the company to the debenture holder, specifying the money the former owes to the latter.
- Fixed maturity date: Debentures are debt instruments with specific maturity dates outlining when the debenture holder will receive the initial investment back from the issuing company.
- Fixed interest payouts: Debenture holders are entitled to periodic interest payments at a fixed rate. Interest is generally paid either on a half-yearly or annual basis. Interest rates on debentures can vary depending on the company, industry, and market conditions.
- No ownership rights: Holding a company’s debentures does not signify ownership in the said company, meaning debenture holders do not have voting rights in the company.
- Redeemability: Debentures can be redeemed by the issuing company at par, premium, or discount.
- Transferability: Debentures are transferable, meaning debenture holders can sell, trade, or transfer them freely in the secondary market.
- Multiple types: Companies can issue various types of debentures to raise funds. Redeemable, irredeemable, secured, registered, bearer, and unsecured debentures are the most common ones. Interest rates, redemption rules, and conversion rights can vary depending on the type of debenture issued.
Reviewing the Different Types of Debentures
Companies can borrow funds through different types of debentures, depending on their specific objectives. Here’s a list of the various types of debentures companies can issue to raise funds:
- Secured debentures
When assets of the issuing company act as collateral for debentures, they are classified as secured debentures. If the company fails to repay the debt on the maturity date due to insufficient funds, it must sell the mortgaged assets to repay these dues.
- Unsecured debentures
As the name implies, unsecured debentures are not issued against collateral security, but simply backed by the credibility of the company. The issuing company does not offer any protection on the interest payments or even principal repayment.
- Convertible debentures
A convertible debenture is a type of debt instrument that offers the holder the option to convert the debenture into equity shares of the issuing company. But it is important to note that this conversion may be allowed at a specific ratio and after a certain period of time.
As such, convertible debentures can be subdivided into fully and partly convertible options. Fully convertible debentures can be converted entirely into equity, while only a limited portion can be converted into stocks for partly convertible debentures based on the terms and conditions of the debenture deed.
- Non-convertible debentures
Non-convertible debentures or NCDs cannot be converted into equity stock of the issuing company. They remain regular fixed-income debt securities throughout the set tenure.
- Redeemable debentures
Redeemable debentures carry a specific maturity date. The issuing company is obligated to repay the loan amount to the debenture holder by this predetermined date.
- Irredeemable debentures
Irredeemable debentures or perpetual debentures do not carry a fixed maturity date. Debenture holders receive periodic interest payments, but the principal remains invested with no specific redemption date. The issuing company can repay the principal after a long time or when it is liquidating.
- Registered debentures
Registered debentures are debt instruments for which the credentials of the investors, including their name, bank details, and address are recorded by the issuing company.
- Bearer debentures
Investor details are not registered by the issuing company in case of bearer debentures. These debentures are transferred by way of delivery.
Difference Between Debentures and Shares
Differences between debentures and shares are outlined below:
| Parameter | Debentures | Shares |
| Nature | Debt instruments issued by a company to raise funds. | Equity ownership in the issuing company. |
| Status of the holders | Debenture holders are creditors of the issuing company having a fixed claim on interest payments and principal repayment. | Shareholders hold equity in the company, making them part owners of the concerned organisation. |
| Return on investment | The return on investment is predetermined since debentureholders receive a fixed interest on the investment. | The return on investment can vary depending on market conditions and the profitability of the company. |
| Type of return | Investors earn returns via fixed interest payments and principal repayment. | Investors earn returns through dividend payouts and capital appreciation. |
| Voting rights | Debentureholders do not have ownership or voting rights in the company. | Shareholders have the power to vote and partake in key decisions like choosing the board of directors. |
| Possibility of conversion | Can be converted into shares. | Cannot be converted into debentures. |
| Risk and reward | Less risky than shares due to the fixed claim on interest payments and principal repayment. | More riskier than debentures because capital appreciation depends on the company’s performance. |
Differences Between Debentures and Bonds
The following table sums up the differences between debentures and bonds:
| Parameter | Debentures | Bonds |
| Definition | Debentures are typically unsecured debt instruments issued by companies to raise funds. | Bonds are debt securities issued by governments, corporations, and other entities with the promise of periodic interest payments and principal repayment at maturity. |
| Issuer type | Primarily issued by companies in the private sector to raise capital. | Issued by a broad range of entities including governments, financial institutions, and corporations. |
| Risk | Unsecured debentures carry a higher risk than bonds. | Risks can vary depending on the credit rating of the issuer. |
| Return | Fixed interest payments. | Fixed or floating interest returns depending on the type of bond in question. |
| Priority during liquidation | Debenture holders have a lower priority for payments during liquidation. | Bondholders are prioritised for repayment in case of liquidation. |
| Convertibility | Convertible debentures can be converted into equity shares. | Generally, bonds cannot be converted into shares. |
What Are the Advantages of Debentures?
Debentures offer certain benefits to both the issuing company and investors. The chief advantages of debentures are listed below:
- Regular income for investors: Investors can rest assured about their income from debenture investments since these instruments offer fixed interest payments. This can offer investors a predictable income source even during times of market uncertainty.
- Access to capital without reducing equity ownership: Since debentures do not confer ownership rights on the investor, companies can raise capital without giving up equity ownership in the venture.
- Liquidity: Debentures are tradable in the secondary market, making them comparatively liquid debt instruments. If the investor requires immediate access to funds, they can choose to sell the debenture in the secondary market.
- Lower cost of capital: Debentures are an attractive financing option since the interest paid on debentures is tax-deductible.
- Minimum risk for holders: Interest on debentures is payable even if the issuing company records losses.
What Are the Risk Factors While Investing in Debentures?
Like any other type of debt instrument, debentures also carry certain risks. As an informed investor, one must understand these risk factors carefully before investing in debentures. We’ve summed up the various risk factors below:
- Credit risk: Credit risk is the possibility that the issuing company may default on its interest payment or principal repayment obligations. You can manage this risk by investing in secured debentures issued by companies with high credit ratings.
- Liquidity risk: Liquidity risks may arise if the market for trading certain debentures is limited.
- Interest rate risk: If interest rates rise in the market, the interest rates on existing debentures may become less valuable, resulting in a fall in the debenture’s market value.
- Inflation risk: Inflation can erode the purchasing power of the fixed interest payments received from debentures over time. Moreover, investors can also have to bear the opportunity cost of missing out on investing in other instruments that offer better, inflation-beating returns.
Conclusion
In summation, debentures are designed to help companies raise funds without giving up equity shares and for investors to earn a fixed and regular income. These types of debt instruments are ideal for companies looking to raise capital to fund growth and investors seeking a steady income. However, before investing or issuing debentures, all concerned parties should understand the various types of debentures, their advantages, and risks to make an informed choice.
