What are Debentures?

  •  5 min read
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  • 28 Dec 2023
What are Debentures?

Key Highlights

  • The Latin term "debreere", which means borrowing or taking a loan, is used for debenture.
  • It is a debt instrument that can be or cannot be secured by any collateral.
  • Governments and firms can use them to raise capital by borrowing public funds.

A debenture is a document that, when accepted, certifies a debt under the enterprise's general authorization. It consists of an agreement for principal repayment at a set time, intervals, or at the business's discretion, as well as interest payments at a fixed rate on predetermined dates, typically once or twice a year. Bonds, Debenture Inventory, and any other securities of an enterprise, whether or not they include a charge on the enterprise's assets, are all considered "debentures" under Section 2(30) of The Companies Act, 2013.

Debentures are equivalent to conventional bonds, but they are not guaranteed. And they are unsecured debt types with no collateral or assets. The issuer's credit rating is the only criterion for investors to choose between investments. Although interchangeable, "bond" and "debenture" differ slightly. Bonds are backed by collateral or assets, as opposed to debentures.

The debentures are classified into two categories: converted and non-convertible.

1. Convertible debentures

An issuer of long-term debt is a convertible debenture. It can convert any loan into equity shares of the company in a flexible manner. It allows both debt and equity to be used by investors, being a hybrid of financial products. Thus, a loan can be converted into shares by investors. Otherwise, they could take the traditional route, hold the loan until maturity, and receive interest payments.

For a firm with adequate future growth potential, it is appropriate to convert debentures into equity. The interest rate is the only drawback, however, which is much less than that of other fixed-income investments.

2. Non-convertible debentures

A non-convertible debenture is a tradition that cannot be converted. In this case, the investor will receive its principal and interest at maturity. These debentures may be secured or unsecured secured nonconvertible debenture is tied to the company's collateral.

In other words, investors could receive money through liquidation if a company went bankrupt. Conversely, if a company goes bankrupt, secured, non-convertible bonds have no assets to back them up.

The features of debentures are as follows.

  1. It is a formal commitment from the issuing business that the holder will receive the agreed-upon amount.

  2. The company issues a debt instrument with the maturity date referred to in the certificate. It sets out the period for repayment of principal amount and interest at maturity.

  3. A fixed interest rate shall be paid periodically, either half-yearly or annually, to the holders. Interest rates on this loan vary according to the company, existing market conditions, and the character of business operations.

  4. According to the deed, an assurance of repayment has been given for this longer-term debt instrument with a fixed deadline. They may also be reimbursed at par, premium, or discount.

  5. The shareholders will be creditors of the undertaking. Until the company requests their opinion in exceptional circumstances, they will not have any voting rights at corporate board meetings.

The advantages of debentures are as follows.

  1. A debenture is a debt instrument issued by a company that guarantees a fixed interest rate.
  2. Compared to equity and preference shares, the issuance of subordinated debentures constitutes one of the most efficient means for raising funds in a company.
  3. They are instruments of liquidity and can be traded on a stock exchange.
  4. The shareholders of debentures shall not be entitled to vote at the company's meetings.
  5. Therefore, the interest of equity shareholders is not diminished.
  6. The issue of debentures may have advantages in the event of inflation, as they provide a certain interest rate.
  7. The holders are at low risk, as interest is paid even if the company were to be liquidated.

The drawbacks of debentures are as follows.

  1. In case of no profit, interest and principal are deemed a financial burden for the company.
  2. The debenture holder is the company's creditor. In addition to the interest rate and the principal amount, they cannot companies profits fall in times of depression, and interest is hard to pay.
  3. Holders of the debentures do not have voting rights. Therefore, they are not in a position to decide on management decisions.
  4. There is a large cash outflow during the redemption procedure of debentures.
  5. The company's creditworthiness is adversely affected when it makes a late payment.

Conclusion

Investors should consider several factors when investing in debentures to make an investment decision. They must assess the issuing company's standing, reliability, and financial stability. A broker's timely research reports can give insight into the underlying business of an issuer. At any cost, make sure that companies with low ratings are avoided.

FAQs on Debentures

The debenture is not a loan of its own, but it is the security document attached to that loan. An unsecured loan, which means the lender has no control over the company's assets, is a loan without a debenture or an alternative form of security.

The debenture is a type of bond. In other words, rather than collateral or physical assets, it is an unsecured loan certificate issued by the company and backed by credit. The maturity is based only on the issuer's creditworthiness.

Using debentures can be encouraged to stimulate longer-term funding for growth in a business. In comparison with other forms of lending, it is also cost-efficient. Bond interest is usually fixed for the lender and must be paid before dividends are delivered to the shareholders.

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