Among various debt instruments, debentures are one class of instruments that do not get secured by collateral. They have more than 10 years of the term. The issuer’s reputation and creditworthiness are taken into consideration when debentures are issued at a fixed rate of interest. By means of debenture, the government and the companies issue loans. It can be termed as the IOU bond between the purchaser and the issuer. Companies, when in need of an extension, borrow money at a fixed interest rate and thus, use debenture for the expansion purpose.
Definition and Purpose of Debenture
As per corporate finance, a medium-to-long-term debt can be termed as debentures which are used by the government and large companies for borrowing money and investing with a fixed interest rate. A debenture, in legal terms, can be referred to as certificates of loan or a loan bond which have the evidence of the fact that the company borrowing debentures has the liability to pay a particular amount of money along with interest after a specified time. The money the company raises by putting the debentures to use becomes a part of the capital structure of the company. But, it does not still get to be the share capital.
Debentures are movable property which is issued by a company in the form of indebtedness and/or a certificate. The debentures may or may not have a charge on the company assets. The debenture holders are the creditors of the company borrowing the money. But, the debenture holders are not considered to be the shareholders of that very company.
Types of Debentures
In layman’s terms, the debentures can be of four types. Each type is described in the following section in an elaborate way.
1. Secured and Unsecured Debentures
Secured debentures are bonds that come with collateral issued. The party that issues the bond offers assets or other property which can be taken possession of in case of failure of the debt repayment by the issuer.
Unsecured debentures, on the other hand, do not have collateral security with it. No asset or property is allotted for such debentures. The creditworthiness of the issuer is all that is taken into consideration here.
2. Registered and Bearer
Companies have their own register of debenture holders. Those debentures which are recorded in these registers are referred to as registered ones. But those which can be transferred by the simple delivery method are termed as bearer debenture.
3. Convertible and Non-convertible
Those debentures which can be converted, i.e. turned into equity shares, can be termed as convertible debentures. This conversion is possible only after a specific time period is over. Debentures, which cannot be converted into equity shares are marked as non-convertible debentures.
4. First and Second
Not all debentures are paid at the same time. Debentures which are paid before other similar debentures are known as first debentures. These have the first charge over the company assets. Second debentures are those the repayment of which follows that of first debentures.
Advantages of Debentures
If investors have their eyes fixed upon incomes with fewer risks associated, debentures are the appropriate thing. There are no voting rights involved with debentures. Thus the control of equity shareholders on the management is not diluted. Another advantage of debentures is that it is less costly an affair to finance via them compared to the equity capital. This is because the interest on debentures is compatible with the tax deduction.
The company which takes the loan in the form of debenture does not have to make the profits a part of it. Thus it is advantageous for the companies also. Even when the sales and earnings are relatively stable, the debentures can be put to use without any worries.
Disadvantages of Debentures
Once a debenture is issued, the borrowing capacity is automatically reduced. Also, even if the company is facing financial strains, it has to repay the debts on the specified date. This is especially true with redeemable debentures.
Moreover, the earning of a company is permanently burdened with the issue of the debenture. So, if the earning fluctuates, the risk becomes greater too.
So, debenture, in a nutshell, is a loan capital of a particular company. It is up to the demand of the company or government what type of debenture they would choose to fulfil their purpose. The main reason for issuing a debenture is raising the capital funds. Corporation or government, both should verify the demerits well before issuing a debenture to avoid undesirable consequences in future.
FAQs on Debentures: Meaning, Types, and Features
1. What is a debenture in company finance?
A debenture is a written instrument that acknowledges a debt issued by a company under its common seal. It serves as a formal certificate for a loan, where the company promises to pay a fixed rate of interest and repay the principal amount on a specified future date. Essentially, when you hold a debenture, you are a lender to the company, not an owner. These are a key component of a company's borrowed funds.
2. What are the key features of debentures?
Debentures have several distinct features that set them apart from other financial instruments. The primary features are:
Debt Instrument: It represents borrowed capital, making the holder a creditor of the company.
Fixed Rate of Interest: Debentures carry a pre-determined, fixed rate of interest, known as the coupon rate, which is a charge against the company's profits.
No Voting Rights: Since debenture holders are creditors and not owners, they do not have any voting rights in the company's management.
Repayment: The principal amount of the debenture is repaid at the end of a specified period, except in the case of irredeemable debentures.
Security: Debentures may be secured by a charge on the company's assets, offering protection to the holder in case of default.
3. What are the main types of debentures a company can issue?
Companies can issue various types of debentures based on different criteria:
Based on Security:
- Secured Debentures: Backed by a charge on the company's assets.
- Unsecured Debentures: Not backed by any specific asset.
Based on Convertibility:
- Convertible Debentures: Can be converted into equity shares after a certain period.
- Non-Convertible Debentures: Cannot be converted into shares.
Based on Permanence:
- Redeemable Debentures: Repayable after a specific period.
- Irredeemable (Perpetual) Debentures: Not repayable during the company's lifetime.
Based on Registration:
- Registered Debentures: Recorded in the company's register of members.
- Bearer Debentures: Transferable by mere delivery, like currency notes.
4. How are debentures fundamentally different from shares?
The primary difference lies in their nature: debentures represent debt, while shares represent ownership. This leads to several key distinctions:
Status of Holder: A debenture holder is a creditor of the company, whereas a shareholder is an owner.
Return: Debenture holders receive a fixed rate of interest, which is a charge against profit. Shareholders receive a dividend, which is an appropriation of profit.
Repayment: Debentures are typically issued for a fixed term and are repaid on maturity. Equity shares are not repaid during the company's existence.
Control: Debenture holders have no voting rights and no control over management, unlike equity shareholders. You can explore a detailed comparison in our guide on the difference between shares and debentures.
5. What does the percentage shown before a debenture's name, like '9% Debentures', signify?
The percentage prefixed to a debenture's name, such as '9% Debentures', represents the coupon rate. This is the fixed annual rate of interest that the company is legally obligated to pay to the debenture holders on the nominal (face) value of their debentures. This interest is a mandatory payment, regardless of whether the company makes a profit or not. For more details on this calculation, see our topic on interest on debentures.
6. Why would a company choose to issue debentures instead of more shares?
A company might prefer issuing debentures over shares for several strategic reasons:
No Dilution of Control: Issuing debentures raises funds without diluting the ownership and control of existing shareholders, as debenture holders do not get voting rights.
Lower Cost of Capital: The interest paid on debentures is tax-deductible, which reduces the company's tax burden. This often makes debt a cheaper source of finance compared to equity.
Trading on Equity: If the company's return on investment is higher than the interest rate on debentures, the surplus profit goes to the equity shareholders, increasing their earnings per share.
Flexibility: Debentures are issued for a fixed period and can be redeemed, providing flexibility in managing the company's capital structure.
7. What is the main difference between a bond and a debenture?
While both are debt instruments, the core distinction between a bond and a debenture lies in collateral. Generally:
Bonds are typically secured debt instruments. They are backed by a specific asset or collateral of the issuer. If the issuer defaults, bondholders have a claim on that asset. Government entities and large corporations often issue bonds.
Debentures are often unsecured. Their repayment is backed solely by the issuing company's general creditworthiness and reputation, not by any specific asset. They are commonly issued by private companies to raise capital.
For an in-depth look, you can read about the difference between bonds and debentures.
8. What do 'secured' and 'unsecured' debentures mean?
The terms 'secured' and 'unsecured' refer to whether the debentures are backed by the company's assets:
Secured Debentures are those that have a 'charge' on the assets of the company. This means specific assets are pledged as security for the debentures. If the company fails to repay the debenture holders, they can sell these assets to recover their money. This makes them a safer investment.
Unsecured Debentures, also known as 'naked' debentures, have no such charge on any asset. The holders are treated as general creditors of the company. In case of financial trouble, they are paid only after the claims of secured creditors have been settled.
