What is a debenture?
A debenture is a long-term loan (usually more than 10 years) that a company or government issues to the public to fund the capital requirements of the organisation. Once you buy a debenture from a company, you become a creditor, and the company is obligated to pay you the principal and the promised interest rate.
- Once you buy a debenture, you will receive the promised interest rate and the principal amount on maturity.
- Coupon rates on debentures can be fixed or floating. In the case of floating rates, the interest rate of the debenture will reset at regular intervals.
- If you buy a debenture from a reputed and creditworthy issuer, your money is secured, and you can also enjoy higher interest rates than bank FDs.
- In the event of liquidation of the company (the company going bankrupt), debenture holders will be paid before preferred shareholders and equity shareholders. So you can consider your money safer than investments made by the organisation’s preferred and equity shareholders.
- As there is no collateral to back debentures, the rate offered is slightly high, which will help tackle the ever-increasing inflation rate and preserve your capital.
Features of Debentures
Debentures have the following features:
- Credit rating. There is no collateral to safeguard your investment in debentures. The interest rate offered by the debenture issuer depends on its creditworthiness (denoted by a credit rating). If the issuer’s financials are sound, the rate offered on debentures will be lower as the risk is lower.
- Interest Rate: The coupon rate is the interest the issuer offers on debentures. The rate can be either fixed or floating. If the rate is fixed, you will receive a fixed interest rate on your principal amount at regular intervals. In the case of a floating coupon rate, the base rate is tied to a benchmark like LIBOR or MIBOR, and when the benchmark changes, the coupon rate also changes.
- Maturity Date: Debentures are not perpetual like equity or preferred shares—they have a maturity date. On the day of maturity, the principal and accrued interest are paid to the debenture holder by the issuing company.
- Convertibility of Debenture: Some businesses issue debentures, which can be converted (convertible debentures) into shares after a certain period. This makes it easier for investors to gain business ownership and enjoy financial gains when revenue increases. The issuer benefits from low-cost borrowing because convertible debentures have a lower interest rate than non convertible debentures.
- Sinking Fund: Debentures are obligations that companies need to obey. On the day of maturity, the debenture issuer will have to pay the whole principal amount along with accrued interest. Organisations create a fund to pay the debenture holders to avoid the sudden cash requirement. Slowly, they set aside a portion of their profit to pay the debenture holders.
- Liquidity: Debentures are liquid. Like shares, they trade in the capital market, and the price of the debentures changes as per demand. If the market interest rate increases, the price of debentures in the market falls, and vice versa.
Types of Debentures
There are eight major types of debentures, based on four different categorisations:
Based on convertibility:
Convertible debentures can be converted into equity shares of the issuing company at a fixed rate. If you notice that the company’s share price is going up drastically, you can convert your debentures, get equity shares, and enjoy the rising price. The convert option is an advantage you are receiving, so the interest rate offered for a convertible debenture is less than for a non-convertible debenture.
Non convertible debentures
Non convertible debentures are traditional debentures that cannot be converted into stock by the issuing business. So, to make up for the fact that investors can’t turn it into cash, it pays a higher interest rate than convertible debentures.
Based on security:
A debenture is secured if it is issued against a firm’s assets. If the business defaults or lacks the resources to repay the loan, it might reimburse the money by selling the related asset(s). Creating a sinking fund to pay debentures on maturity reduces the risk of default and makes it secure.
Unsecured debentures are debentures that are given out by a company without any claim on its assets.
Based on tenure:
Redeemable debentures are debentures that the issuing company can redeem after a specified period. The debenture issuer will generally redeem a debenture when the rate offered in the debenture is higher than the market rate. The issuer will redeem your debenture and then issue new debentures at a lower market rate.
Irredeemable debentures cannot be redeemed or repaid while the corporation is still in operation. So as a debenture holder, you are safe, as you can enjoy the coupon payments for longer.
Based on registration:
Registered debentures are debentures in which all information about their holders, such as names, addresses, etc., is kept in a separate register at the company’s headquarters. So, a proper name transfer is required to sell your debenture.
These debentures are transferred through simple delivery, preserving no specific record in the business register. So, you can just sell it to any person, and no documentation is required.
Advantages of debentures
Debentures have various advantages for investors and the company.
Non-dilution of ownership
Compared to businesses that issue share capital, where control is diminished because of the shareholder’s voting rights, holders of debentures do not have any voting rights. Therefore, you will not be able to participate in the company’s decision-making.
More affordable source
Debentures are a more cost-effective mode of debt for the company as the costs of listing and flotation are lower than those of equity capital.
Advantages to investors:
Investors receive a fixed annual income regardless of whether the firm is profitable. A corporation is required to pay interest on the issued debentures. So you will have a steady income. With equity owners, the dividend is entirely based on the revenue generated. If there is no profit, the company is not obligated to pay dividends to equity shareholders.
In case of liquidation, the claim of the debenture holder comes before equity and preferred shareholders, which makes debentures more secure.
Inflation-protected debentures secure your money from rising inflation rates. The coupon rate is tied to an inflation index, so whenever inflation increases, the coupon rate also increases.
Debentures are unsecured bonds that enterprises and governments commonly issue. Compared to secured bonds, secured by collateral, unsecured bonds are riskier as they do not provide any asset backup if the issuer defaults; they rely only on the business’s reputation and creditworthiness. At Piramal Finance, you will find authentic and personalised information on financial products and services, including various loans and financial calculators.