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Debentures: Meaning, Features, Advantages, Disadvantages Research Team | Posted On Saturday, October 13,2018, 12:45 PM

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Debentures: Meaning, Features, Advantages, Disadvantages



A debenture is a long-term debt instrument which is issued by a Company, institution or even by the Government, with no collateral pledged. The debenture is all about the integrity of the borrower. Debentures are unsecured and fall behind secured debt when it comes to residual claims. A debenture is unsecured with no liens/pledges on assets.

In simple words, a debenture is a debt instrument which is not backed by collateral. Debentures are used to raise medium and long-term funds from the public. Debentures are backed by the creditworthiness of the Company issuing them and the reputation of the issuer. Governments and Companies issue debentures to raise capital.

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Debentures: Meaning, Features, Advantages, Disadvantages

Let’s take a look at the features of debentures. Go through the points below to understand debenture features.

Features of debentures:

1. Debentures have a maturity term:

Debentures offer long-term funds to Companies and mature after a specific time. Debentures must be repaid within a specific time and time period is stipulated in the issue. The Company has to repay the Principal amounts on debentures within the requisite date or debenture holders will force the Company to close operations. Debenture holders are the creditors of the Company.

A Company can issue perpetual debentures or irredeemable debentures which don’t have a maturity date. There is no fixed time period within which principal repayments must be made. The perpetual debenture holder cannot force the Company to make the payments. Does this mean Companies will never redeem debentures? No, definitely not. Perpetual debentures have maturity dates and they will definitely mature, making repayment a certainty.

2. Debentures offer interest

Debentures offer a fixed rate of interest. The Company has to fulfil the legal obligation of paying interest on due dates. Interest repayments do not depend on Company earnings. If a Company has no earnings or is in deep losses, it has to fulfil interest obligations to holders of debentures.

What happens if a Company defaults on debenture interest? The debenture holders will force the Company to shut down or take the Company to Court.

3. Debenture holders have claims on assets

When it comes to claims, debenture-holders get priority above equity and preference shareholders. They have to be paid first before any payment is made to equity and preference shareholders, if the Company is being liquidated. Debenture holders have claims only on Principal and Interest amounts and not on Company surplus amounts.

Secured debenture holders have claims over Company assets which have been pledged / mortgaged to them. Secured debenture holders enjoy priority over unsecured debenture holders. If assets are insufficient, then secured debenture holders are paripassu (on an equal footing) vis-a-vis unsecured debenture holders.

3. Debenture cannot exercise control over management of the Company

Debenture-holders are not Company owners, but merely creditors. They cannot control the management of the Company. They don’t enjoy voting rights to elect Company Directors or to force the management to abdicate. At the time of liquidation, they have greater rights over Company assets vis-a-vis equity holders and if they are not paid, they can force the management to leave and take control of the Company.

4. Debentures have the call feature:

Debentures have the call feature which allows a Company to redeem debentures at a fixed price before maturity. Call price is generally higher than issue price.

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Types of debentures:

1. Naked debentures:

Naked debentures do not enjoy security against assets. They are just like unsecured debenture holders.

2. Secured debentures

These debentures are secured against assets of the Company. If there’s a default in principal and interest payments, debenture holders sell Company assets and get claims settled.

3. Bearer debentures

Bearer debentures can easily be transferredand are just like negotiable instruments. Any citizen can purchase a bearer debenture for a consideration. Bearer debentures have coupon/interest rate. These are attached to the debenture, hence the name, bearer debenture.

4. Registered debentures:

Registered debentures have a procedure vis-a-vis transfer. The person who transfers and the transferee sign a transfer voucher. The transfer voucher is sent to the Company along with registration fees.

The registered debenture holders name is entered in a register. Interest is sent only to the registered debenture holder.

5. Redeemable Debentures

On expiry of the time period, the debentures are redeemed. You enjoy periodic interest payments, but principal is returned only at the end of the time period. Redeemable debentures have fixed time periods.

6. Convertible Debentures

Company’s issue convertible debentures and debenture-holders can exchange debentures for equity shares, after expiry of a specified time period.

7. Irredeemable Debentures:

Irredeemable debentures cannot be redeemed within a Company’s lifetime. Irredeemable debentures are paid on winding up of the Company or in case of default. The Company has the right to redeem debentures after giving debenture-holders, due notice.

Advantages of debentures: 

  • Conservative investors prefer debentures as they offer security on the investment.
  • Debenture holders earn interest as a charge against profits. The date/rate of payment are fixed. Debenture holders get paid whether the Company makes a profit or not.
  • Rate of interest is generally lower than dividends paid on preference shares.
  • The Company can raise long-term finance without diluting equity or a stake sale.
  •  If a Company is overcapitalized (Has too much capital), it simply issues redeemable debentures.

Disadvantages of debentures:

  • Companies with fluctuating income should not go for debentures.
  • The Company has to pay interest on debentures, irrespective of whether it makes a profit or not.
  • Debentures are secured against assets and the Company requires a lot of fixed assets.
  • Debenture holders do not enjoy voting rights.
  • Company could struggle paying principal and interest in a recession.
  • Debentures are secured against assets. Companies will not be able to pledge assets to banks and raise loans.

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