Updated Mar 24, 2022

What is Debentures?

What is Debentures?

To secure funds and capital, corporations and governments issue long-term debt instruments called debentures. The interest on the loan is fixed, subject to the company’s reputation. Moreover, no collateral is essential for backing up the debt. This guide covers the types of debentures, their features, and pros and cons.

Debentures in detail

‘Debre’ - a Latin word - is the root of debentures. In the simplest terms, it means to borrow or loan. A debenture can be considered marketable security or a type of investment. Since it is debt capital, it falls under the debt category of a company’s balance sheet. A debenture has a fixed period and interest rate paid yearly or half-yearly.

Investors cannot claim any assets in case of any deficits. Large corporations with triple A-credit ratings usually issue debentures as no collateral is involved. A company can benefit from its privileged status by borrowing money without security.

A debenture is a legal certificate that covers how much money the investor gave (principal). In addition, it also has information about the interest rate and payment schedule. Investors collect their principal amount when the debenture matures or reaches the end of its term amount.

Salient features of debentures

Debentures are unique and different from other investments. Here’s how:

• Since debentures are instruments of debt, debenture holders are creditors for the company. They carry a fixed interest rate.

• The date of redemption and repayment amount is mentioned on the certificate, known as Debenture Deed. The certificate is enacted under the company’s seal.

• Debenture holders are not instruments of equity, so they are only creditors and not owners. Consequently, they do not enjoy any voting rights.

• The company must repay the debenture holders even in case of loss.

Types of debentures

Based on security:

1. Secured debentures - Charge is set against a secured asset in case of a default. If the company lacks enough funds to repay the debentures, they can sell the asset to settle the loan. The charges are further divided into fixed (against a predetermined asset) and floating (against all of the firm’s assets).

1. Unsecured debentures - Neither fixed nor floating charges secure such debentures. They are uncommon in India.

Based on tenure:

1. Redeemable debentures - After a specific period ends, such debentures are payable. The payment could be a lump sum at the expiry date or in installments spanned over time. Also, such debentures are redeemable at par, discount, or premium.

1. Irredeemable debentures - As the name suggests, they are perpetual with no fixed date of their payability. They can be redeemable when the company undergoes liquidation or after an unspecified time interval.

Based on convertibility:

1. Fully convertible debentures - If the debenture holders wish, they can convert their shares into equity after a specified time. If done so, they will become shareholders in the company.

1. Partially convertible debentures - Debenture holders have the option to convert their debentures partly into equity shares. Likewise, they will be shareholders as well as creditors of the company.

1. Non-convertible debentures - Holders cannot convert such shares into equity. Therefore, the debentures would remain so until they mature. Non-convertible debentures are also the most common of the three.

Pros of debentures

Debentures are highly rewarding for investors as the interest rate is much higher than bonds or any other investment. Additionally, they can exchange their convertible shares for equity. Debenture holders are at a zero-risk level since the loan is secured and the interest is payable even if the company suffers loss.

A company can acquire the required funds without diluting its equity. Most importantly, debenture loans are not restricted in terms of how much they can borrow, unlike traditional loans. They also stimulate long-term planning and funding at a relatively cheaper rate.

Cons of debentures

Although profitable for the investors, debentures are a financial burden for the company by carrying inflationary risk. It is largely because the interests are payable, whether the company earns a profit or suffers default. The company may end up losing more than it borrowed.

Moreover, debentures can create a liquidity imbalance as they demand a significant cash flow. Debentures become expensive during an economic crisis due to their inflexible interest rates.

Conclusion

In brief, debentures are easy loans for organisations to acquire funding. They are usually not backed by any collateral and depend on the company’s credit performance. Therefore, investors should weigh various factors like credibility and coupon rates before adding debentures to their portfolios.