What are Debentures?
Meaning, Definitions, Features, Types, Advantages and Disadvantages of Debentures
Meaning of Debentures
If a company needs funds for extension and development purpose without increasing its share capital, it can borrow from the general public by issuing certificates for a fixed period of time and at a fixed rate of interest. Such a loan certificate is called a debenture. Therefore, debentures are a way for issuers to borrow money from investors with a promise of regular interest payments and repayment of the principal amount at maturity, while investors receive a fixed income and rely on the issuer’s creditworthiness.
Definitions of Debentures
The concept of debentures has been defined by various authors and experts in finance and accounting. Here are a few definitions from different perspectives:
1. Investopedia
“A debenture is a type of debt instrument that is not secured by physical assets or collateral. Instead, it is backed only by the general creditworthiness and reputation of the issuer.”
2. John J. Hampton (in “Introduction to Financial Management”)
“Debentures are long-term securities yielding a fixed rate of interest, issued by a company and secured only on the general creditworthiness and reputation of the issuer.”
3. Robert W. Kolb (in “Financial Derivatives: Pricing and Risk Management”)
“Debentures are a form of debt instrument that represents a loan to a company or government. They are typically not backed by collateral but by the issuer’s ability to meet its financial obligations.”
4. C.R. Batten and H. J. H. Williams (in “Corporate Finance: Principles and Practice”):
“Debentures are a type of long-term borrowing instrument used by companies to raise funds. They usually come with a fixed interest rate and may be either secured or unsecured.”
5. Paul G. Keat and Philip K. Y. Young (in “Managerial Economics: Economic Tools for Today’s Decision Makers”):
“Debentures are financial instruments that denote a loan to a company or government, paying a fixed interest rate over a specified period and generally without physical collateral.”
6. J. Jay Choi (in “Fundamentals of Financial Management”):
“Debentures are debt securities issued by corporations or governments that offer fixed interest payments and are typically not backed by specific assets.”
Features of Debentures
The important features are as follows:
1. Debenture holders are the creditors of the company carrying a fixed rate of interest.
2. Debenture is redeemed after a fixed period of time.
3. They may be either secured or unsecured.
4. Interest payable on a debenture is a charge against profit and hence it is a tax deductible expenditure.
5. Debenture holders do not enjoy any voting right.
6. Interest on debenture is payable even if there is a loss.
Different Types of Debentures
A company can issue different types of debentures for raising funds for long term purposes. Different forms of debentures are given and discussed below:
1. Ordinary Debenture
Ordinary debentures are debt securities issued by a company or government that represent a straightforward form of borrowing. They offer a fixed rate of interest and are repayable at maturity, but they do not include additional features such as convertibility or callability. Generally, these are unsecured, meaning they are not backed by specific assets of the issuer. Instead, they rely on the issuer’s creditworthiness.
Purpose and Use
i. For Issuers: They are a straightforward way to raise capital. They are simpler to issue and manage compared to more complex debenture types.
ii. For Investors: They provide a predictable income stream from fixed interest payments and return of principal at maturity. They are suitable for investors looking for stable returns without additional features.
2. Mortgage Debenture
It is issued by mortgaging an asset and debenture holders can recover their dues by selling that particular asset in case the company fails to repay the claim of debenture holders.
Purpose and Use
i. For Issuers: They provide a means to raise capital with the added benefit of offering security to investors, which can be advantageous in terms of attracting investment and possibly achieving lower interest rates.
ii. For Investors: They offer greater security compared to unsecured debentures, as they are backed by specific assets. This reduces the risk of loss in case the issuer defaults.
3. Non-convertible Debentures
A non-convertible debenture is a debenture where there is no option for its conversion into equity shares. Thus the debenture holders remain debenture holders till maturity.
Purpose and Use
i. For Issuers: NCDs are a way to raise capital without diluting ownership through the issuance of equity shares. They offer a fixed-cost form of debt financing.
ii. For Investors: NCDs provide a predictable income stream through regular interest payments and the return of principal at maturity. They are suitable for investors seeking stable returns and lower risk compared to stocks.
4. Partly Convertible Debentures
Partly Convertible Debentures are debt instruments issued by companies where a portion of the debenture can be converted into equity shares of the issuing company, while the remaining portion is treated as a non-convertible debt that remains as a fixed-income investment.
Purpose and Use
i. For Issuers: PCDs offer a way to raise capital while also providing an incentive for investors through the conversion feature. The convertible portion can attract investors who are interested in potential equity upside, while the non-convertible portion provides immediate fixed-income benefits.
ii. For Investors: PCDs provide a blend of fixed income and potential equity participation. Investors receive regular interest payments and have the opportunity to benefit from the company’s stock appreciation through the convertible portion.
5. Fully Convertible Debenture
Fully convertible debentures are those debentures which are fully con-verted into specified number of equity shares after predetermined period at the option of the debenture holders.
Purpose and Use
i. For Issuers: Fully convertible debentures are a tool for raising capital while minimizing immediate dilution of equity. They allow companies to attract investors who are interested in potential future equity participation, potentially at lower interest rates compared to non-convertible debentures.
ii. For Investors: FCDs offer the potential for capital appreciation through conversion into equity, along with the fixed income provided by the interest payments before conversion. They are suitable for investors who are interested in benefiting from the company’s future growth.
6. Redeemable Debentures
It is a debenture which is redeemed/repaid on a prede-termined date and at predetermined price. These are fixed-income securities with a defined maturity date when the issuer is obligated to repay the principal amount to the debenture holders. These debentures provide investors with a predictable return on their investment through periodic interest payments and the repayment of the principal at maturity.
Purpose and Use
i. For Issuers: Redeemable debentures allow companies or governments to raise capital while providing a fixed timeline for repaying the debt. The redeemable feature helps manage cash flows and financing needs by specifying when the principal will be repaid.
ii. For Investors: They provide a predictable income stream through regular interest payments and a clear repayment schedule for the principal amount. Investors can plan their investments with a known maturity date, reducing uncertainty about the return of their capital.
7. Irredeemable Debenture
Such debentures are generally not redeemed during the lifetime of the com-pany. So, it is also termed as perpetual debt. Repayment of such debenture takes place at the time of liquidation of the company.
Purpose and Use
i. For Issuers: Irredeemable debentures provide a long-term source of capital without an immediate obligation to repay the principal. This can be advantageous for managing long-term financing needs while retaining flexibility in repayment.
ii. For Investors: These debentures offer a steady income stream through regular interest payments. They are suitable for investors seeking stable returns over a long period, with the understanding that the principal repayment is not guaranteed within a specific timeframe.
8. Registered Debentures
Registered debentures are those debentures where names, address, serial num-ber, etc., of the debenture holders are recorded in the register book of the company. Such debentures cannot be easily transferred to another person.
Purpose and Use
i. For Issuers: Registered debentures allow issuers to maintain a clear record of ownership, which helps in managing interest payments and communication with debenture holders. It also provides an added layer of security and administrative control.
ii. For Investors: They offer the benefit of secure ownership and direct communication with the issuer. They are suitable for investors who prefer having their ownership formally recorded and verified.
9. Unregistered Debentures
Unregistered debentures may be referred to those debentures which are not recorded in the company’s register book. Such a type of debenture is also known as bearer debenture and this can be easily transferred to any other person.
Purpose and Use
i. For Issuers: Bearer debentures offer a simplified process for issuing and transferring securities, but they also carry risks related to security and record-keeping. They are less commonly used in modern finance due to these risks and regulatory changes.
ii. For Investors: They provide easy transferability and anonymity, which can be attractive to investors seeking privacy. However, they also come with risks related to security and loss.
Advantages and Disadvantages
Advantages of Debentures
For Issuers:
1. No Ownership Dilution:
Issuing debentures does not dilute the ownership or control of the company. Unlike equity financing, debentures do not involve issuing new shares.
2. Fixed Interest Payments:
The interest on debentures is fixed, which provides predictability in financial planning and budgeting.
3. Tax Benefits:
Interest payments on debentures are generally tax-deductible, reducing the company’s taxable income.
4. Flexibility in Terms:
Companies can structure debentures with varying features, such as convertibility, redemption options, and security, to meet specific financing needs.
5. Attractive to Investors:
Debentures can be attractive to investors seeking fixed income with varying risk levels (secured vs. unsecured, convertible vs. non-convertible).
For Investors:
1. Predictable Income:
Debentures offer a fixed rate of interest, providing a steady and predictable income stream.
2. Priority over Equity:
In the event of liquidation, debenture holders are prioritized over equity shareholders in the repayment of principal and interest.
3. Variety of Options:
Investors can choose from different types of debentures (convertible, non-convertible, secured, unsecured) to match their investment preferences and risk tolerance.
4. Transferability:
Many debentures are transferable, allowing investors to buy and sell them in secondary markets, enhancing liquidity.
Disadvantages of Debentures
For Issuers:
1. Fixed Financial Obligations:
Issuers are required to make regular interest payments regardless of their financial condition, which can strain cash flow, especially during economic downturns.
2. Debt Burden:
Accumulating too much debt through debentures can increase the company’s leverage and financial risk, potentially impacting its credit rating and borrowing costs.
3. Redemption Risk:
Issuers may face challenges in managing the redemption of debentures, particularly if they are irredeemable or callable under certain conditions.
4. Potential for Lower Credit Rating:
High levels of debt can lead to a lower credit rating, making it more expensive to raise additional capital in the future.
For Investors:
1. Interest Rate Risk:
Fixed interest payments may become less attractive if market interest rates rise, leading to potential capital losses if sold before maturity.
2. Credit Risk:
There is a risk of default if the issuing entity faces financial difficulties, especially with unsecured or lower-rated debentures.
3. Limited Upside:
Non-convertible debentures do not offer the potential for capital appreciation, unlike equity investments.
4. Liquidity Issues:
Some debentures, particularly those with specific features or those issued by smaller companies, may have limited liquidity in secondary markets.
Summary
Debentures offer several benefits, including the ability to raise capital without diluting ownership and providing fixed income to investors. They come with risks related to fixed financial obligations for issuers and potential credit and interest rate risks for investors. Balancing these factors is crucial for both issuers and investors when considering debentures as a financing or investment option.
Read More:
