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.

Understanding Debentures Meaning

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 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.

Differences Between Debentures and Shares

When comparing debentures to shares, it's essential to understand their fundamental differences. Debentures are a form of debt, while shares represent ownership in a company. This means that debenture holders are creditors, whereas shareholders are partial owners of the company.

Another key difference lies in the returns. Debentures typically offer fixed interest payments, making them a more predictable investment. On the other hand, returns on shares come in the form of dividends, which can fluctuate based on the company's performance. Additionally, in the event of liquidation, debenture holders have a higher claim on assets compared to shareholders.

Below is a table with a quick comparison:

Differences Between Debentures and Loans

While both debentures and loans are debt instruments, they serve different purposes and have distinct characteristics. Debentures are typically issued by companies to raise long-term capital, whereas loans are often taken from banks or financial institutions for various needs. One of the primary differences is in the issuance and trading. Debentures can be traded in the secondary market, providing liquidity to investors. Loans, however, are agreements between the borrower and lender and are not traded. Additionally, debentures usually come with fixed interest rates, while loans can have variable interest rates based on market conditions.

Explaining Debentures with An Illustration

To better understand debentures meaning, let's consider an illustration. Imagine a company, XYZ Ltd., needs to raise capital for expansion. Instead of taking a loan from a bank, XYZ Ltd. decides to issue debentures. Investors purchase these debentures, lending money to XYZ Ltd. In return, the company agrees to pay a fixed interest rate annually and repay the principal amount at the end of the term. For instance, if XYZ Ltd. issues debentures worth ₹1,00,000 with an interest rate of 8% for a period of 5 years, the investors will receive ₹8,000 annually as interest. At the end of the 5 years, the company will repay the ₹1,00,000 principal amount. This arrangement provides the company with the required capital and offers investors a steady income stream.

Types of Debentures

There are two types of debentures : convertible 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.

Features of Debentures

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.

Advantages of Debentures

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.

Disadvantages of Debentures

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.

Risks Involved for Investors

Investing in debentures comes with its share of risks. One of the primary risks is credit risk, which is the possibility of the issuing company defaulting on interest payments or the repayment of the principal amount. Companies with lower credit ratings are considered riskier, and their debentures may offer higher interest rates to compensate for this risk.

Another risk is interest rate risk. If market interest rates rise, the fixed interest rate on debentures might become less attractive, leading to a decline in their market value.

Additionally, debentures are subject to inflation risk, where the fixed interest payments may lose purchasing power over time due to rising inflation rates.

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.