Debenture Redemption Reserve: Meaning, Application, Necessity
A debenture is a loan where companies borrow money from the general public and private institutions. Subscribers of the debentures will receive interest and the principal amount on maturity or at defined intervals. The Debenture Redemption Reserve (DRR) is a provision mandated by the RBI to protect investors in case of a payment default. Let us understand the meaning of Debenture Redemption Reserve.
All businesses require funds to sustain and grow. There are many options for companies to raise funds. Apart from the owner’s capital, companies raise funds through debt and by issuing shares. Raising funds through debt involves issuing debentures or borrowing money in the form of loans.
Indian companies that issue debentures are required to set a special fund called the Debenture Redemption Reserve (DRR). The purpose of this fund is to make sure they can repay the debentures as promised and lower the risks of not being able to pay them back. The Debenture Redemption Reserve ensures there’s enough money to fulfill the promises to debt holders.
What is the Debenture Redemption Reserve (DRR)?
The Indian Companies Act 1956 was amended in the year 2000 to add the provision for DRR (Debenture Redemption Reserve) to safeguard the interests of debenture holders. Maintaining a debenture redemption reserve is a mandatory requirement for all companies in India that issue debentures.
A debenture issuing company is required to create a debenture redemption reserve, a pool of funds for each debenture issue. If a company goes into liquidation, the debenture investors can be paid from the funds available in the DRR. Even when collateral backs the debenture, the investors need not wait for the collateral to be liquidated. Collateral liquidation is a long process. In adverse situations, DRR funds are saviours for investors.
There have been changes in the DRR requirements over the years. DRR was mandatory for all companies initially. In August 2019, the Ministry of Corporate Affairs amended the provision. It exempted companies listed on Indian exchanges from keeping a debenture redemption reserve.
In March 2014, the Ministry of Corporate Affairs mandated that companies need to create a DRR fund that is 50% of the value of total funds raised in the debenture issue. However, this limit was revised later to 25%. Right now, the DRR fund requirement limit is 10% of the debenture issue funds.
Debentures are a crucial financial tool for corporate India to raise funds and finance their working capital and expansion plans. The debenture redemption reserve is an important metric to attract more investors. The DRR adds to the degree of safety and reduces the risk for debenture holders.
How Does a Debenture Redemption Reserve Work?
Companies issuing debentures are required to maintain a Debenture Redemption Reserve – presently, 10% of the amount raised through the debenture issue. In case the company defaults on the payment, the debenture holders are paid from this Debenture Redemption Reserve (DRR). The DRR is supposed to be funded by the profits earned by the company in the given financial year.
For example, if company A issues a debenture of Rs 1 crore today, it will mature after five years. A reserve of 10 lakhs (10% of debenture value) must be created within one year from the debenture issue date. But this amount need not be added all at once in one tranche. The mandate allows the issuer to add a certain percentage each year till maturity. A part of the value of the debenture amount maturing the following year must be maintained in the current year before April.
Classification of Debentures
Debentures are issued across many avenues and classified based on their nature. Here is a general classification of debentures based on certain aspects:
Secured Debentures: These are supported by certain corporate assets. The holder may claim this security in the event of default.
Unsecured/ Naked Debentures: No asset is used to secure them.
Convertible Debentures: These have a set conversion time after which they can be changed into equity shares.
Non-convertible Debentures: Debentures that are not convertible into equity shares are known as non-convertible debt.
Redeemable Debentures: These must be paid back after a certain amount of time.
Irredeemable/ Perpetual Debentures: There is no set date for maturity.
Callable Debentures: Debentures that the corporation can call back before maturity.
Puttable Debentures: The holder may repurchase them from the company before maturity.
Status or Position:
First Debentures: Paid first at the time of liquidation.
Second Debentures: Paid after the first debentures have been settled.
Registered Debentures: These are listed in the company’s register of holders of debentures.
Bearer Debentures: No registration is necessary, and ownership remains with the holder.
Fixed Rate Debentures: Carry a fixed interest rate throughout their tenure.
Floating Rate Debentures: The interest rate varies based on some benchmark or market indicator.
Methods of Redemption of Debentures
When a firm redeems its debt instruments, it pays back the debt instruments’ principal. The following are the different ways that debentures may be redeemed:
Redemption by Open Market Purchase:
Companies have the option to purchase and then cancel their own debentures on the open market. Using this strategy, businesses can benefit from market circumstances and redeem debentures at a profit.
You can redeem convertible debentures by changing them into business equity shares. At the time of issuance, the conversion conditions are specified. By converting the holders of the debentures into shareholders, this strategy lowers the company’s liabilities.
This strategy involves redeeming debentures at the end of a specified period out of capital, which effectively means that the money is paid back from capital rather than from earnings. This process is typically used to redeem irredeemable bonds.
Businesses use their revenues to fund a Debenture Redemption Reserve (DRR). This reserve receives a yearly transfer of a specific amount of profit, which is used to repay debentures. Redeemable debentures are redeemed using this procedure.
Using Sinking Funds:
A business establishes a sinking fund into which it deposits a set sum on a regular basis. The debentures are redeemed using the fund and accrued interest by buying them on the open market or by direct repayment.
Call and Put Alternatives:
Some debentures have attached call or put options, allowing for early redemption before the maturity date. Call options are the company’s right to purchase debentures, while put options are the debenture holder’s right to sell debentures back to the company.
Is the Debenture Redemption Reserve Applicable to All Issuers?
The Debenture Redemption Reserve provision applies only to debentures issued after the amendment to the Companies Act, 1956 in the year 2000. However, there are exemptions to this amendment:
- The DRR provision does not apply to Public Financial Institutions (PFIs). PFIs are entities owned by the central government with at least a 51% stake, e.gLife Insurance Corporation of India (LIC), , Industrial Finance Corporation of India (IFCI), Industrial Credit and Infrastructure Corporation of India (ICICI), Industrial Development Bank of India (IDBI).
- DRR is not required for All India Financial Institutions (AIFIs) for public and private debentures. AIFIs operate under the RBI’s purview, e.g., NABARD, SIDBI, Export-Import Bank of India, and NHB.
- All housing finance companies, also known as HFCs, registered with the National Housing Bank are exempt from DRR.
- DRR does not apply to Non-Banking Finance Companies (NBFCs) registered with the RBI.
- All scheduled banks are exempt from DRR creation.
- Any company listed on the NSE or BSE is not required to maintain DRR.
Note: In the event that an unlisted HFC or NBFC goes ahead with a public debenture issue, the company must maintain a debenture redemption reserve. When a company issues a partially convertible debenture, DRR is required only for the nonconvertible amount of the debenture issue. The Ministry of Corporate Affairs allows these exemptions to let companies raise funds easily without too many impediments.
Earmarking of Funds
There are clear guidelines by the RBI for earmarking funds towards the debenture redemption reserve:
- Funds for the debenture redemption reserve must be taken from the profits earned by the company and no other source. A debenture redemption reserve is created from funds marked for paying dividends to the shareholders. The fund must be created to pay the debenture liability in the next financial year. Companies that fail to create this reserve are liable to pay investors a 2% interest on the amount as a penalty.
- The formula used to calculate the amount for the debenture redemption reserve is 10% of the outstanding debentures with fewer funds already present in DRR. For NBFCs and HFCs, the percentage of the reserve is 15% instead of 10%.
- The company’s management is responsible for maintaining the required funds in the debenture redemption reserve at all times. They also must ensure that the funds are utilised only for debenture liability repayment and for no other purpose.
Investment of Funds
The RBI allows funds in the debenture redemption reserve to be invested in certain securities. It ensures that the money does not remain idle and earns a return for the issuer. The debenture redemption reserve can be invested in the following:
- Fixed deposits with the authorised banks under the RBI list of scheduled banks.
- Government short-term bond issues or treasury bills and commercial papers.
- Government bond issues with longer tenure.
These investments must be made before April 30th of the fiscal year. The value of investments must be equal to the value in the debenture redemption reserve, i.e., the value on both sides must be the same in the ledger.
Utilisation of Debenture Redemption Reserve
The investments or securities are redeemed when the debenture payment is due. The proceeds from these investments must be used to settle the debenture obligations only and for no other purpose.
The investments or deposits in DRR funds bear a return or profit. This profit can’t be added to the debenture redemption reserve amount. It should be transferred to the company’s general reserve once the debenture payments are complete.
A debenture is a reasonably safe debt investment that earns a fixed return for the investor. An investor must look for a good credit rating before investing in a debenture. Risks are also inherent in a debenture investment, like default risk due to bankruptcy or other financial concerns. The debenture redemption reserve is dealt with in Section 117C of the Indian Companies Act, 1956, to safeguard the debenture holder’s interest. It is an exclusive reserve maintained only for debenture repayment purposes.
FAQs about Debenture Redemption Reserve
What are the risks of investing in debentures?
Risks of investing in debentures include interest rate risk (you may not get the promised interest rate), liquidity risk (you may not be able to sell your debentures when you are in need of funds), and fraud risk (the collateral associated with the debenture might not exist).
Is debenture redemption reserve mandatory?
The debenture redemption reserve is mandatory for all companies that issue debentures except Public Financial Institutions (PFIs), All Indian Financial Institutions (AIFI), HFCs, NBFCs, scheduled banks, and listed companies.
Is DRR a free reserve?
No, DRR does not form part of the free reserve. The DRR is created for the sole purpose of debenture repayment; the funds cannot be deployed for any other purpose.
What concerns does the debenture redemption reserve address?
The debenture redemption reserve creates a pool of funds that shields the debenture investors from the risk of debenture default.
What are the debenture redemption reserve rules?
The Debenture Redemption Reserve (DRR) rules mandate that a company issuing debentures must create a DRR equivalent to at least 10% of the outstanding debentures, according to the Companies (Share Capital and Debentures) Rules, 2014, amended in 2019.