Private corporations often reach out to the general public to raise funds, through debt and equity instruments. Companies issue shares through Initial Public Offerings (IPOs) and Follow-on Public Offerings (FPOs) and/or raise debt through bonds and debentures. The cost of these funds to the company differs based on the instrument it issues, the tenure of the instrument, and the company’s credit rating.
Investors invest in these companies as a way to obtain returns on their savings. They evaluate their own risk profile and financial goals before investing in an instrument. Those looking for fixed returns with lower risk opt for debt instruments, and those looking for higher returns and willing to take more risk, invest in equity. Investments in debt or equity instruments of corporations demands for an analysis of the entity’s fundamentals in addition to other material information.
The underlying objective is to be a part of the company’s growth and benefit mutually. While bonds and stocks have become fairly popular amongst investors, many still do not understand debentures. Read on to understand the meaning, features, merits, and demerits of debentures.
What are Debentures?
Companies can raise debt from investors through bonds and debentures. A debenture is a document acknowledging a loan with a specified interest rate and a promise to pay the face value to the investors on maturity. This loan, like bonds and equity, is fungible and tradeable.
When you buy a debenture, you lend your money to the issuing company and receive interest payouts regularly and the principal amount at maturity. Debentures can be either secured or unsecured. Due to higher risk, unsecured debentures come with a higher rate of interest.
Why Companies Issue Debentures?
A company can raise funds through equity or debt. Equity capital is expensive to the company, as the investors expect higher returns on the stock. In the case of debt, a bank loan comes with restrictions on the usage of capital. Debentures give the companies a certain degree of flexibility. Companies can issue debentures to raise capital even when their assets are pledged elsewhere.
Features of Debentures
Tenure: The maturity date of a debenture is mentioned on the certificate. On this date, you will receive the principal amount.
Rate of Interest: Investors receive a fixed interest rate on the debt, which is predetermined. It could be credited quarterly, semi-annually or annually.
Security: The debt raised by a debenture is usually not secured by any assets. The only guarantee is the reputation of the company and its creditworthiness.
Promise of Repayment: While issuing debentures, backing them up with collateral is optional. Therefore they come with a promise of repayment after the tenure.
Collateral: Backing a debenture with collateral is optional. In the case of a secured debenture, the trustee holds the assets on behalf of the issuer company.
Stakeholders: There are three main stakeholders in the issue of a debenture:
- Debenture Holder: A debenture holder is an investor who buys a debenture and lends money to the issuing company.
- Issuer: The company issuing debentures is called the issuer.
- Trustee: The trustee is an independent third party that ensures that the issuer complies with all provisions of the Companies Act and upholds the interest of the debenture holders by doing periodic due diligence.
Types of Debentures
There are two types of debentures:
- Convertible Debentures: These debentures can be converted into shares of the company. The company pre-specifies the conversion ratio, date of conversion, trigger events for conversion, etc. Debentures can be fully convertible, partially convertible and optionally convertible.
- Fully Convertible Debentures can be converted into company shares at a date and conversion rate specified at the time of issue.
- Partially Convertible Debentures can be partly converted to shares. The conversion ratio is pre-decided.
- Holders of optionally convertible debentures have the choice of converting the debenture into shares of the company.
- Non-Convertible Debentures: These are pure debt instruments with no option to convert them into equity shares.
Now, let’s evaluate the merits and demerits of debentures for both investors and the issuing company.
Advantages of Debentures
- Fixed return: Debentures offer a fixed return, providing the investors a certain degree of income security.
- Lower risk: The risk of investing in debentures is lower than equity. Also, in case of bankruptcy, debenture holders are paid out before the shareholders.
- Tradeable: The debentures can be traded on stock exchanges. This, to an extent, solves the liquidity problem.
- Convertible: The option of converting debentures into shares could lead to even higher returns (applicable only for convertible debentures).
For the Issuing Company
- Low Cost of Funds: Raising funds through debentures is cheaper for the company than raising it through issuing equity shares.
- Management Control: Issuing equity dilutes management control as it comes with voting rights. Through debentures, this control is not diluted.
- Cheaper During Inflation: If the issuing company foresees inflation, debentures could be an even cheaper source of funds due to fixed interest rates. With inflation, the real rate of interest for the company will reduce.
Disadvantages of Debentures
- Limited Returns: The return to investors is limited to the interest payment. They do not have any share in the company’s performance.
- No Voting Rights: Being a debt instrument, the holders do not have any control over the company management.
For the Issuing Company
- Fixed liability: Whether the company makes profits or not, it must pay the debenture holders. It could be difficult for the company to meet its liabilities during a recession.
- Creditworthiness: A default on a single payment will affect the company’s creditworthiness and, therefore, the future cost of debt.
Difference Between Debentures and Shares
Companies issue both debentures and equity shares to raise capital for various purposes. While debentures are fungible and tradeable like equity, the two differ on multiple accounts.
- Type of instrument: Shares are equity instruments, and debentures are debt instruments. Shareholders, therefore, are part owners of the company, while debenture holders are creditors to the company.
- Return: Investing in company shares usually comes with higher returns than debentures of the same company.
- Priority in case of bankruptcy: In case of bankruptcy, debenture holders get paid before the shareholders.
- Voting Rights: Debenture holders have no way to influence managerial decisions. Shareholders, however, can do so as they have voting rights.
- Maturity: Debentures have a fixed maturity, after which they are paid off. Shares, on the other hand, continue in perpetuity except in some instances when they could be bought back.
Shares vs Debentures
You may refer to the table below to get an idea of the key differences between, shares and debentures:
|Type of Instrument||Equity||Debt|
|Risk||High risk as returns depend on the performance of the company.||Medium risk since the returns are fixed but there is no collateral backing (usually).|
|Return||Potential for high returns.No guarantee of dividends.Capital appreciation depends on company performance.||Unsecured debentures have higher returns than secured debentures but lower than equity potential|
|Voting Rights||Come with voting rights as equity holders are part owners of the company.||No voting rights|
|Payment on Liquidation||Lowest priority of being repaid.||Paid after bondholders and before shareholders.|
|Convertibility||No option to convert into anything else.||Can be converted into shares based on specified trigger factors.|
How Can You Buy Debentures?
Debentures can be bought and sold on stock exchanges like BSE and NSE. Therefore, all you need to invest in them is a Demat account with a securities broker. You can buy a newly issued debenture from a publicly listed company or trade in the secondary market.
It is important to check the credit rating of the issuer before investing in a debenture. Rating agencies like CRISIL, ICRA and CARE give credit ratings. The rating is a score obtained by considering various factors which could impact the company’s ability to repay the debt on time.
Debentures offer a sweet spot with lower cost to the company than equity and higher flexibility of use of funds than traditional debt. For an investor, debentures offer higher returns than secured debt sans the uncertainty surrounding the equity market. On a side note, if you are risk averse and want to invest in debt, you may also choose to invest in bonds which although offer slightly lower returns than debentures but are more secure due to collateral backing. You must take the credit rating of the issuing company into account before investing in debentures or bonds.
How do debentures work?
A debenture is essentially a type of loan raised by a company from the general public. In India most debentures are secured by a collateral (although there can also be unsecured debentures). Debentures usually offer higher returns that fixed deposits (in the range of 9–11%).
Is TDS applicable on interest on debentures?
TDS (Tax Deducted at Source) is deducted from the interest earned on debentures if the interest amount for the given financial year is more than Rs. 5,000. However, the total income tax payable on the interest earned from debentures is as per your slab rate. Notably, no TDS is applicable on listed debentures.
How are bonds and debentures similar?
Both bonds and debentures are debt instruments used to raise funds by corporations. Both come with a face value, interest rate and maturity date. During liquidation, bond and debenture holders receive their money before the company’s shareholders.
Who is a debenture holder?
The investors who buy debentures and lend funds to the issuer are called debenture holders. They receive a document stipulating the interest rate, maturity date and the promise of loan repayment at maturity. This document is called the debenture.
Chandhana is a budding investment professional with growing expertise in the capital markets. She has completed her Bachelors in Business Administration with a specialisation in Finance from Christ (deemed to be) University,Bangalore. She is also a CFA L2 candidate. She is currently working as an Investment Associate at Wint Wealth.