In this article, we will discuss Debenture, its feature, types, advantage & disadvantage.
What are Debentures?
A debenture is a type of bond or other debt instrument that is unsecured by collateral. Since debentures have no collateral backing, they must rely on the creditworthiness & reputation of the issuer for support. Both corporates and governments frequently issue debentures to raise capital or funds.
- Similar to most bonds, debentures also pay periodic interest payments called coupon payments. Like most bonds, debentures are also documented in legal contract between the bond issuer and the bondholders. Some debentures can be converted into equity shares while others cannot.
- The contract specifies features of a debt offering such as maturity dates, the timing of interest or coupon payments, the method of interest calculation & other features. Only Corporates & Governments can issue debentures. Governments typically issue long-term debentures—those with maturities of longer than 10 years & are generally considered as low-risks investment.
- Debentures of corporates are unsecured. They have the backing of only the financial viability & creditworthiness of the underlying company. These debentures pay an interest rate & are redeemable or repayable on a fixed date. A company typically makes these scheduled debt interest payments before they pay stock dividends to shareholders.
- It is advantageous for companies since they carry lower interest rates & longer repayment dates as compared to other types of loans and debt instruments.
Features of Debentures
- Interest Rate – Coupon rate is determined, which is the rate of interest that the company will pay the debenture holder or investor. This coupon rate can be either fixed or floating. A floating rate might be tied to a benchmark such as the yield of the 10-year treasury bond and will change as the benchmark changes.
- Credit Rating – Company’s Credit Rating & debenture’s credit rating impacts the interest rate that investors will receive. Credit-rating agencies measure the creditworthiness of corporate and government issues. These entities provide investors with an overview of the risks involved in investing in debt. Any debt instrument receiving a rating lower than a BB is said to be of speculative grade.
- Maturity Date – For non-convertible debentures, the date of maturity is also an important feature. This date dictates when the company must pay back the debenture holders. The company has options on the form the repayment will take. Most often, it is as redemption from the capital, where the issuer pays a lump sum amount on the maturity of the debt. Alternatively, the payment may use a redemption reserve, where the company pays specific amounts each year until full repayment at the date of maturity.
Debentures Risks to Investors
- Debenture holders may face inflationary risk. Here risk is that the debt’s interest rate paid may not keep up with the rate of inflation. For example – Inflation causes prices to increase by 5%. If the debenture coupon pay interest at 4%, the holders may see a net loss, in real terms.
- Debentures may carry credit risk & default risk. These are only as secure as the underlying issuer’s financial strength. If the company struggles financially due to internal or macroeconomic factors, investors are at risk of default on the debenture. A debenture holder would be repaid before common stock shareholders in the event of bankruptcy.
Example of a Debenture
- Example of a Government Debenture would be Government Treasury Bond (T-Bond). T-bonds help finance projects and fund day-to-day governmental operations.
- Some T-Bonds trade in the secondary market. In the secondary market through a financial institution or broker, investors can buy and sell previously issued bonds. T-bonds are nearly risk-free since they’re backed by the full faith and credit of the government. However, they also face the risk of inflation and interest rates increase.
Advantage & Disadvantage of Investing in Debentures
|Debentures are debt instruments issued by the company that promises a fixed interest rate on the due date
|Payment of interest and principal becomes a financial burden for the company in case of no profits
|Issuing debentures is one of the most effective ways to raise funds for a company compared to equity or preference share
|Debenture holders are the creditors of the company. They cannot claim profits beyond the interest rate and principal amount
|These instruments are liquid and can be traded on the stock exchange
|During the recession, the company’s profit declines, and it becomes difficult to pay interest
|Debenture holders do not have voting rights in the company meetings. Thus, it does not dilute the interest of equity shareholders
|Debenture holders have no voting rights. Hence, they do not have control over management decisions
|During inflation, issuing debentures can be advantageous as they offer a fixed interest rate
|During redemption process of debenture, there is a large amount of cash outflow
|The holders bear minimum risk because interest is payable even in case of loss of the company
|Default payment has adverse effects on the creditworthiness of the company
Types of Debentures
- Registered v/s Bearer – Registered debentures are registered to the issuer. The transfer or trading in these securities must be organized through a clearing facility that alerts the issuer to changes in ownership so that they can pay interest to the correct bondholder. Bearer debenture are not registered with the issuer. The owner (bearer) of the debenture is entitled to interest simply by holding the bond.
- Redeemable v/s Irredeemable – Redeemable debentures clearly indicates exact terms and date by which the issuer of the bond must repay their debt in full. Irredeemable (non-redeemable) debentures, on the other hand, do not hold the issuer liable to repay in full by a certain date. Because of this, irredeemable debentures are also known as perpetual debentures.
Convertible v/s Non-Convertible
1 Convertible debentures are bonds that can convert into equity shares of the issuing corporation after a specific period. These are hybrid financial products with the benefits of both debt and equity.
Companies use debentures as fixed-rate loans and pay fixed interest payments. Companies use debentures as fixed-rate loans and pay fixed interest payments.
However, the holders of the debenture have the option of holding the loan until maturity and receive the interest payments, or convert the loan into equity shares.
These are attractive to investors who want to convert their debenture holding into equity if they believe the company’s stock will rise in the long term. However, the ability to convert to equity comes at a price since convertible debentures pay a lower interest rate compared to other fixed-rate investments.
2. Non-Convertible Debentures
These are the traditional debentures that cannot be converted into equity of the issuing corporation. To compensate for the lack of convertibility investors are rewarded with a higher interest rate when compared to convertible debentures.
Debentures measures of Risk
These are debt securities, they tend to be less risky than investing in the same company’s common stock or preferred shares. Debenture holders would also be considered more senior & take priority over those other types of investments in the case of bankruptcy. These debts are not backed by any collateral, however, they are inherently riskier than secured debts. Therefore, these may carry relatively higher interest rates than otherwise similar bonds from the same issuer that are backed by collateral.
Disclaimer: The information contained in this website is provided for informational purposes only, and should not be construed as legal/official advice on any matter. All the instructions, references, content, or documents are for educational purposes only and do not constitute legal advice. We do not accept any liabilities whatsoever for any losses caused directly or indirectly by the use/reliance of any information contained in this article or for any conclusion of the information.