Debentures

A debenture is an unsecured loan taken by a company or government, backed only by their creditworthiness instead of any asset or collateral.
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What is a Debenture
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3 mins
19 February 2025

Key takeaways

  • Debentures are debt instruments issued by companies or government entities to raise capital.
  • Corporations and governments often issue debentures as a common means to raise capital.
  • Debenture holders are company creditors, getting periodic interest and the principal back at maturity.
  • Debentures rely solely on the issuer's creditworthiness and reputation, lacking specific collateral.

A debenture is a type of long-term debt instrument that is not backed by collateral. Debentures are backed only by the creditworthiness and reputation of the issuer. Both corporations and governments frequently issue debentures to raise capital or funds. It is essentially a form of loan that investors provide to the issuer, typically a corporation or government entity. In return, the issuer promises to repay the principal amount along with periodic interest payments at a predetermined rate.

What are the key features of debentures?

Here are certain features of debentures you should know:

  1. Fixed maturity date: Debentures have a specific maturity date, indicating when the issuer must repay the principal amount to the debenture holders. This date is predetermined and provides clarity on when investors can expect to receive their initial investment back.
  2. Interest payments: Debentures typically pay periodic interest to investors. This interest can be fixed, meaning it remains constant throughout the debenture's life, or it can be variable, in which case it fluctuates based on market conditions or a predefined formula.
  3. No ownership rights: Debenture holders are creditors of the issuer, not owners. They do not have any ownership or voting rights in the issuing company or organisation. Their relationship with the entity is that of a lender.
  4. Secured or unsecured: Debentures can be secured or unsecured. Secured debentures are backed by the issuer's assets, which serve as collateral, providing a level of security for the principal amount and interest payments. Unsecured debentures (also known as "unsecured debentures" or "debenture stock") lack collateral and are riskier but often offer higher interest rates to compensate for the increased risk.
  5. Transferability: Debentures are generally transferable, meaning investors can sell, trade, or transfer them to other parties in the secondary market. This feature enhances liquidity and allows investors to exit their investments if needed.
  6. Various types: Debentures come in various forms, each with unique characteristics. These include convertible debentures, non-convertible debentures, redeemable debentures, and irredeemable debentures. The specific type of debenture affects its terms and conditions, such as conversion rights, redemption provisions, and interest rates.

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What are the different types of debentures?

Let us learn more about the different types of debentures:

1. Convertible debenture

  • A convertible debenture is a type of debt instrument that provides the holder with the option to convert the debenture into equity shares of the issuing company after a specified period.
  • This conversion feature allows investors to benefit from potential capital appreciation if the company's stock price rises, thereby transitioning from being creditors (debt holders) to shareholders.

2. Non-convertible debenture (NCD)

  • Non-convertible debentures are debt instruments that cannot be converted into equity shares. They remain as fixed-income securities throughout their tenure.
  • NCDs offer investors regular interest payments at a predetermined interest rate until the maturity date, providing a predictable income stream.

3. Registered debenture

  • A registered debenture is a debenture for which the issuer maintains a register of debenture holders. These debentures are linked to specific investors, and the issuer has a record of the holders' names and contact information.
  • Registered debentures provide a level of security for investors, as they can be easily traced in case of loss or theft.

4. Unregistered debenture

  • Unregistered debentures, in contrast to registered debentures, do not have a specific record of individual debenture holders. They are considered bearer debentures.
  • Unregistered debentures can be transferred more easily, as they do not require a formal transfer of ownership, making them more convenient for trading in the secondary market.

5. Redeemable debenture

  • Redeemable debentures are debentures that come with a specific maturity date. The issuer is obligated to repurchase them from debenture holders at face value upon maturity.
  • Investors receive both periodic interest payments and the return of the principal amount upon maturity, which provides clarity on when the investment will be repaid.

6. Irredeemable debenture (perpetual debenture)

  • Irredeemable debentures, also known as perpetual debentures, do not have a fixed maturity date. They continue indefinitely, and the issuer has no obligation to repurchase them.
  • Investors receive periodic interest payments, and the principal amount remains invested, with no specified date for redemption. These debentures offer a perpetual income stream.

7. Secured debentures

Secured debentures are backed by the company’s assets, ensuring that in the event of a default, debenture holders can recover their investment through these assets. Holders of secured debentures have a legal claim on the collateral tied to the debenture.

8. Unsecured debentures

Also referred to as naked debentures, these are not backed by any collateral. Their repayment relies solely on the issuing company's financial stability and creditworthiness. While they carry a higher risk than secured debentures, they typically offer greater returns to compensate for the risk.

9. Convertible debentures

Convertible debentures come with the option to be converted into equity shares of the issuing company after a predetermined period. These debentures appeal to investors seeking long-term growth potential, as they provide an opportunity to gain ownership in the company.

10. First mortgage or preferred debenture

First mortgage or preferred debentures take priority in asset realization, ensuring that their obligations are settled first in case of liquidation.

11. Second mortgage or ordinary debenture

Second mortgage or ordinary debentures are repaid only after the obligations of first mortgage debentures have been fulfilled during asset realization.

12. Partially convertible debentures

Partially convertible debentures are debt instruments that can be converted into equity shares, but only up to a specified limit or percentage. As a hybrid security, part of the debenture transitions into company shares, while the remaining portion continues as a fixed-income investment.

Each type of debenture serves different investment and financing purposes, catering to the needs of both issuers and investors with varying financial goals and risk preferences.

Difference between debentures and shares

Debentures and shares are both financial instruments used by companies to raise capital, but they differ in several key aspects:

Feature

Debenture

Share

Definition

A loan instrument representing debt owed by the company to the debenture holder.

A unit of ownership in a company, representing equity in its assets and earnings.

Holder status

Debenture holders are creditors (lenders) to the company.

Shareholders are part-owners of the company.

Payment security

Debentures may offer security (collateral) as guarantee for repayment.

Shares typically do not have any security backing them.

Return

Debenture holders receive a fixed interest rate on their investment.

Shareholders may receive dividends, which can vary based on company performance.

Return payment source

Interest payments are made regardless of the company's profitability.

Dividends are paid out of the company's profits.

Control rights

Debenture holders typically do not have voting rights or influence in company management.

Shareholders usually have voting rights and can influence company decisions.

Conversion option

Debentures can sometimes be converted into shares.

Shares cannot be converted into debentures.

Trust deed

A trust deed is often created to protect debenture holders' interests, especially when no collateral is offered.

Shares do not involve a trust deed.

 

Differences between debentures and bonds

Debentures and bonds are both types of debt instruments used by companies and governments to raise capital, but they differ in several key aspects:

1. Definition

  • Debentures: Debentures are unsecured debt instruments issued by companies to raise funds. They represent a form of long-term borrowing where the issuer agrees to pay periodic interest and return the principal amount at maturity.
  • Bonds: Bonds are debt securities that can be either secured or unsecured, issued by governments, municipalities, or corporations. Bonds represent a promise to repay the principal along with periodic interest payments.

2. Issuer type

  • Debentures: Primarily issued by corporations in the private sector to raise capital.
  • Bonds: Issued by a broader range of entities, including governments, municipalities, and corporations.

3. Term usage

  • Debentures: The term "debenture" is often used for corporate debt instruments.
  • Bonds: The term "bonds" is more generic and can refer to debt instruments issued by various entities.

4. Conversion features

  • Debentures: Debentures typically do not have conversion features, meaning they cannot be converted into equity shares of the issuing company.
  • Bonds: Some bonds may have convertible features, allowing bondholders to convert their bonds into equity shares under specific conditions.

5. Risk and return

  • Debentures: Generally considered to carry higher risk compared to bonds, especially unsecured debentures. The return is typically in the form of fixed interest payments.
  • Bonds: May have varying levels of risk depending on factors like the issuer's credit rating. Returns can be fixed or variable.

6. Credit rating

  • Debentures: Issuers of debentures are subject to credit ratings, which impact the interest rate they must offer to attract investors.
  • Bonds: Credit ratings are also applicable to bonds, influencing the interest rate and the perceived credit risk.

Difference between a debenture and a loan

Let’s explore the difference between a debenture and a loan:

1. Debenture

  • A debenture is a type of debt instrument issued by companies to raise capital.
  • It is not secured by physical assets or collateral.
  • Debentures promise to pay interest and principal to the debenture holders.
  • Companies issue debentures to investors, and these investors become creditors of the company.
  • Debentures are typically used for long-term financing.

2. Loan

  • A loan is a sum of money borrowed from a lender.
  • It requires repayment with interest over a specified period.
  • Loans can be secured or unsecured:
    • Secured loan: Backed by collateral (such as property or assets). If the borrower defaults, the lender can seize the collateral.
    • Unsecured loan: No collateral is required, but interest rates may be higher.
  • Banks and financial institutions typically issue loans to individuals and businesses.

In summary, while both debentures and loans involve borrowing money, the key distinction lies in security: debentures lack collateral, whereas loans can be secured or unsecured.

What are the advantages of debentures?

Investing in debentures offers several advantages:

  1. Regular income: Debenture holders receive regular interest payments, ensuring a predictable income stream.
  2. Safety of principal: Secured debentures are backed by the issuer's assets, providing a level of security for the principal amount.
  3. Diversification: Debentures allow investors to diversify their portfolios beyond equities, reducing overall risk.
  4. Liquidity: Most debentures are tradable in secondary markets, providing liquidity to investors.
  5. Fixed returns: Fixed interest rates on debentures offer stability in a fluctuating market.

What are the disadvantages of debentures?

Despite their advantages, debentures also come with certain disadvantages:

  1. Interest rate risk: If interest rates in the market rise, the fixed interest payments on debentures may become less attractive.
  2. Credit risk: Unsecured debentures carry a higher risk of default by the issuer, leading to potential loss of principal.
  3. Market risk: Debenture prices can fluctuate in response to market conditions, affecting their market value.
  4. Lack of ownership: Debenture holders have no ownership or voting rights in the issuing company.

What are the risk factors while investing in debentures?

Investors should be aware of potential risk factors when considering debenture investments:

  1. Credit risk: Assess the issuer's creditworthiness, as default can lead to losses.
  2. Interest rate risk: Understand the sensitivity of debenture prices to changes in interest rates.
  3. Liquidity risk: Some debentures may have limited liquidity in secondary markets.
  4. Market risk: Be prepared for price fluctuations in response to market conditions.

Debenture Stock

Debentures and debenture stocks are often confused, but they are distinct financial instruments. Companies and governments issue debentures (debt securities) to raise capital. Debenture stocks, while also representing debt, function more like preferred stock. Holders of debenture stocks receive dividends from company profits at set intervals.

Debenture stocks carry a similar risk level to other equity investments, but they are secured by a trust deed. This trust offers a degree of protection, allowing stockholders to appoint receivers to liquidate assets if necessary to recover their investment.

In summary, debentures are considered a safer investment. They offer a fixed interest rate regardless of the issuer's profitability, and debenture holders have priority in asset liquidation. However, frequent issuance of debentures can negatively impact a company's balance sheet and creditworthiness.

Conclusion

In conclusion, debentures offer different options for companies to raise money and for people to invest. You can choose between debentures that may convert into company shares or those that simply provide a regular fixed income. Whether a company needs funds for growth, or an investor wants a steady income, debentures can be a good choice. It is important for everyone to understand the different types of debentures and their features, as well as the risks involved.

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Frequently asked questions

What is a debenture with an example?

Debentures are a specific type of business loan, but not all business loans are debentures. A key difference is that debentures are unsecured loans, meaning they aren't backed by collateral. For instance, a loan secured by assets isn't a debenture. Debentures are documented by a formal agreement issued by the borrowing company as a promise to repay the debt, whereas traditional loans are issued by the lending institution.

What are debentures used for?

Debentures are tools used by lenders, like banks, to provide financing to companies and individuals. They allow lenders to secure repayment of a loan by creating a claim against the borrower's assets, even in the event of default. This claim can be either a fixed charge (on specific assets) or a floating charge (on a class of assets).

How do debentures work?

Debentures are used by lenders, like banks, when financing companies or individuals. They give the lender a claim against the borrower's assets, ensuring loan repayment even if the borrower defaults. This claim can be a fixed charge (on specific assets) or a floating charge (on a group of assets).

Is a debenture a loan?

A debenture represents a type of long-term debt instrument issued by a company or government, typically with a fixed interest rate and maturity date. While debentures share similarities with loans, they are distinct in that they are usually unsecured and are backed by the general creditworthiness of the issuer rather than specific assets.

What is bond and debenture?

Bonds are debt instruments issued by large entities like financial institutions, corporations, and governments, and are typically secured by collateral or assets. Debentures, on the other hand, are debt instruments issued by private companies and are unsecured, meaning they are not backed by collateral.

Are debentures assets or liabilities?

From the issuer's perspective, a debenture represents borrowed funds and is a liability. For the investor who holds the debenture (the bondholder), it's an asset representing a loan made to the issuer.

What does 12% debentures mean?

A 12% debenture means that the instrument will pay a 12% interest rate. If it has a face value of Rs 1000, then it will pay Rs 120 (1000*12%) as interest.

How to buy debentures?

Debentures are debt instruments issued by companies to raise loans from the market. They are similar to company fixed deposits, but offer higher returns (10-12%). NCDs can be bought in two ways: (1) subscribe when a company announces NCD or (2) buy later in the secondary market when it is trading.

Are debentures good or bad?

Debentures can be both good and bad. Some advantages of debentures include a higher position in the pecking order for repayment, valuable financial protection for directors, and encouragement of long-term funding. Some disadvantages include a lack of flexibility in interest payments, restrictions imposed by securing the debenture, and the lender's loss of voting rights and profit-sharing.

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