What Are Debentures? Meaning, Types, Features & Risk Factors
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 authorisation. 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. Here’s how:
Debentures vs Bonds
| Parameter | Debentures | Bonds |
|---|---|---|
Definition | A type of debt instrument not necessarily backed by physical assets or collateral. | A debt instrument usually backed by specific assets or government guarantees. |
Security/Collateral | Generally unsecured, though can be secured in some cases. | Generally secured with assets or backed by the issuer’s credit. |
Return/Payout | Usually offer comparatively higher interest rates to compensate for higher risk. | Offer stable but lower interest rates; considered safer investments. |
Convertibility | Can be convertible into equity shares or non-convertible. | Generally non-convertible; remain as fixed-income instruments. |
Read more: Bonds Vs 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:
| Parameter | Debentures | Shares |
|---|---|---|
Nature | Debt instrument | Equity instrument |
Ownership | No ownership rights | Ownership rights |
Returns | Fixed interest payments | Dividends (variable) |
Risk | Lower risk | Higher risk |
Claim in liquidation | Priority over shareholders | After debenture holders |
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.
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 an issue that cannot be converted. In this case, the investor will receive their principal and interest at maturity. 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.
3. Secured debentures
These are backed by the company’s assets for the purpose of repayment in terms of default. Secured debenture holders also tend to have greater protection.
4. Unsecured/naked debentures
As the name suggests, these debentures are not backed by any asset and investors have to, therefore, rely solely on the issuer’s credit worthiness.
5. Redeemable debentures
These debentures are those that are repaid by the issuer after a specific period. The repayment could be either in lumpsum or instalments.
6. Irredeemable/perpetual debentures
These types have no fixed maturity date and are rarely issued in India due to regulatory restrictions. Do note that SEBI does not favour these for retail issuance due to their indefinite risk exposure.
Features of Debentures
The features of debentures are as follows.
-
It is a formal commitment from the issuing business that the holder will receive the agreed-upon amount.
-
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.
-
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.
-
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.
-
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.
-
A debenture is a debt instrument issued by a company that guarantees a fixed interest rate.
-
Compared to equity and preference shares, the issuance of subordinated debentures constitutes one of the most efficient means for raising funds in a company.
-
They are instruments of liquidity and can be traded on a stock exchange.
-
The shareholders of debentures shall not be entitled to vote at the company's meetings.
-
Therefore, the interest of equity shareholders is not diminished.
-
The issue of debentures may have advantages in the event of inflation, as they provide a certain interest rate.
-
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.
-
In case of no profit, interest and principal are deemed a financial burden for the company.
-
The debenture holder is the company's creditor. They are only entitled only to the interest and principal amount, irrespective of the company’s profits. Even during crisis, the company is legally obligated to pay interest to debenture holders.
-
Holders of the debentures do not have voting rights. Therefore, they are not in a position to decide on management decisions.
-
There is a large cash outflow during the redemption procedure of debentures.
-
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.
Read more: What is Non-Convertible Debentures?
This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
