What are the Types of Debentures in India?
Companies are in constant need of funds to meet their working capital expenditures on one hand and fund capital investments of sorts on the other. To provide for the need for funds, corporates turn to the general public to raise capital in the form of loans or equity. Issuing equity means giving ownership of the company to the investors. On the other hand, debt means borrowing funds from institutions or the public with a promise to repay them. Bonds and debentures are two popular forms that debt instruments take.
While bonds are relatively more popular, debentures are a lesser-understood financial instrument. However, with growing financial awareness, investors are looking for all possible options to expand and diversify their portfolios. There are various types of debentures that you can invest in. Let’s understand some popular kinds of debentures that are available for investment to retail investors.
A debenture is a certificate acknowledging a loan with a specified maturity date and interest payment schedule. The loan is fungible and tradeable in the secondary market. It can be secured or unsecured (debentures are usually unsecured). Some of the key features of a debenture are:
- Maturity Date: It is the date when the final loan repayment is due. The issuer is obliged to pay you the entire face value amount by this date.
- Rate of Interest: It is the rate of coupon payments that you may receive monthly, quarterly, half-yearly or annually. The rate could be fixed or floating. All the information on the rate of interest and the payment schedule is pre-specified in the debenture certificate.
- Collateral: Whether a debenture is backed by any assets or not is the issuer’s choice. The asset backing the issuance is referred to as the collateral. Depending on their collateral backing, there are various types of debentures, more of this later.
- Promise of Repayment: The debenture certificate promises to pay the holder a certain amount as interest and the principal amount. The promise holds as much credibility as the company’s reputation and creditworthiness.
Types of Debentures
Let’s understand the different types of debentures that are available for investment. We have segregated the types on the basis of security, tenure, convertibility and registration of the debentures.
On the Basis of Security:
Debentures are classified as secured and unsecured debentures based on the degree of security they provide on the initial investment (capital) of investors in terms of repayment risk.
When a collateral backs the company’s debentures, the debentures are considered to be secure in nature and are thus referred to as “secured debentures”. On the basis of whether the collateral is specific or generic, secured debentures can further be classified into:
- Fixed Charge Debentures: These types of debentures are secured by specific assets of the company; the assets, therefore, cannot be sold without the consent of the debenture holders. The assets serving as collateral remain the same throughout the tenure of the bond.
- Floating Charge Debentures: These debentures are secured by the generic assets of the company. In this case, however, the collateral constituents are dynamic and may change during the tenure of the bond.
These debentures are not backed by any assets, and the only credibility here is the company’s reputation. Unsecured debentures pay a higher rate of interest to compensate for their higher risk. It is prudent to check the credit rating of the company issuing an unsecured debenture before investing.
On the Basis of Tenure:
Another classification of debentures is on the basis of whether the debentures have a defined maturity and whether they can be redeemed post that
Most of the debentures issued by companies are redeemed at a date specified in the debenture certificate. This is the distinguishing feature of redeemable debentures. They can either be redeemed at par value or at a premium to their par value at maturity.
Some debentures have a perpetual life with no pre-specified date of redemption. Repayment of the principal happens only at liquidation. For this reason, the irredeemable debenture holders are the first to be paid in the event of insolvency. The Indian security markets do not permit the issue of such debentures.
On the Basis of Convertibility:
Some debentures come with built-in equity-like features. Based on these, they are classified into convertible and non-convertible debentures.
If you hold convertible debentures, you have the choice of converting your debentures into equity shares of the company on or before a specified time* on account of the occurrence of pre-specified trigger events. These debentures can fully or partially be converted into shares.
Fully Convertible: In this case, you can convert all your debentures into shares.
Partially Convertible: You can only convert some of your debentures into shares.
The conversion to stock happens as per a pre-decided conversion ratio, specified in the debenture certificate. A conversion ratio of 10:1 means that you can get ten shares for every debenture that you hold and so on.
Debentures with pure debt characteristics and no option to convert into equity shares are called non-convertible debentures.
Difference Between Convertible and Non-Convertible Debentures
|Parameter||Convertible Debentures||Non-Convertible Debentures|
|Type||Part debt, part equity||Pure debt|
|Interest rate||Low, as you can opt for conversion of debentures into equity shares||Higher than convertible debentures|
|Value on Redemption||The value depends on the price of the stock when you want to sell the debenture.||The value is fixed and mentioned in the debenture.|
On the Basis of Registration
Debentures are classified as registered and bearer debentures on the basis of registration.
If you hold a registered debenture, your personal details such as name, PAN, and bank details are registered with the issuer. You cannot transfer the debenture to someone else without getting the details changed with the issuer. If you do not do so, the gains accrued from the debenture will continue to be realised in your name.
The holders of these debentures are not registered with the issuer. The gains, therefore, are realised by the bearer of the debenture.
Tax Implications on Debentures
- If you hold the debenture till maturity, the gains from the same will be added to your income, and you will be taxed on it as per your income slab.
- If you sell the debenture before the expiration of one year (for listed debentures) or three years (for unlisted debentures) from the date of buying, before maturity, a Short Term Capital Gains (STGC) tax is applicable as per your income slab.
- If you sell the debenture before expiry but after the expiration of 1 year (for listed debentures) or three years (for unlisted debentures) from the date of purchase, a Long Term Capital Gains (LTCG) tax of a flat 20% shall be applicable. For listed debentures, the LTCG can also be calculated at 10%, without indexation.
Debentures in India are regulated by SEBI (Securities and Exchange Board of India) under the provisions of the Companies Act, 2013. They are safe and established instruments for investment. Variations in tenure, interest payment schedules etc. lead to the creation of different debentures that can be invested in to meet an array of distinct investment goals.
FAQs related to types of debentures in India
Why are debentures attractive to investors?
Debentures usually offer fixed interest payments, guaranteeing a regular income to investors. The risk of investing in them is relatively lower than in equity instruments. They become more attractive if they are convertible debentures, as the final return would be dependent on the stock price of the company, with high upside potential.
Why do companies issue debentures?
Companies issue debentures to raise debt and maintain flexibility over the use of funds. Issuing equity has a higher cost of funds than debentures. Debentures are also preferred when the company is not in a position to raise secured debt.
What are the risks involved in debentures?
The primary risks involved in debentures are:
Interest rate risk: As the interest rate is fixed, the prices of debentures could fluctuate as per the market interest rate.
Credit risk: Since debentures are usually unsecured, the loss severity given default is always more. This mandates the need to check the credit rating of the issuer before buying a debenture.
Who can issue a debenture in India?
According to the Companies Act, 2013 following classes of companies can issue Debentures:
Companies engaged in setting up of infrastructure projects
Infrastructure Finance Companies
Infrastructure Debt Fund NBFCs
Companies permitted by a Ministry or Department of the Central Government or by RBI or by the National Housing Bank or by any other statutory authority to issue debentures.