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What Is Debenture?

IndianMoney.com Research Team | Posted On Thursday, November 01,2018, 05:44 PM

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What Is Debenture?

 

 

A debenture is a debt instrument which is not backed by any security or collateral. The security of the debenture is the credit of the Company issuing the security. Higher the standing of the Company, lower is the interest rate offered on the debenture. Companies use debentures to raise funds in the medium or long-term.

Companies issue debentures as a method of raising loan capital. It is a certificate that says the Company is liable to pay interest. The money raised through debentures does not become part of the capital structure. Capital structure is debt or equity of the Company. Money raised through debentures is not share capital of the Company.

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Features of debentures:

1. Maturity of a debenture:

A Company gets funds for the long-term through debentures. Debentures have to be repaid within a particular time. The Company has to repay the amount borrowed within a particular date. If it fails to do so, creditors start winding up procedures to close down the Company. A Company can issue perpetual debentures which have no fixed time limit to pay back the principal amount.  Creditors cannot force payments on perpetual debentures.

2. Interest on debentures:

Debentures have fixed rate of interest. A Company has a legal obligation to pay interest on debentures, irrespective of the amount it earns. If a Company is suffering heavy losses, it still has to pay interest to debenture holders. Bond holders get priority over preference and equity shareholders when it comes to claims over the Company.

3. Claims over assets of the Company:

Debenture holders enjoy priority over the preference and equity shareholders, when it comes to residual claims over the assets of the Company. This is a claim over Principal and Interest payments and not over the surplus assets of the Company. The secured debentures enjoy a priority over unsecured creditors of the Company vis-à-vis Company assets.

4. Debenture holders don’t have voting rights:

Debenture holders are the creditors of the Company. They don’t enjoy voting rights and debenture holders cannot dismiss the management of the Company.

5. Debentures have a call feature:

Debentures have a call feature which allows the Company to redeem debentures, before the maturity date. Debentures with the call feature provide a huge advantage to the Company vis-à-vis debenture holders. This is why call price is greater than issue price.

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Types of debentures:

  • Unsecured debentures: Unsecured debentures have no security on assets. They are just like unsecured creditors and enjoy the same rights as unsecured creditors.
  • Secured debentures: These debentures enjoy security over the assets of the Company. If the Company defaults on debenture interest, debenture holders sell assets to recover their dues.
  • Bearer debentures: You can purchase bearer debentures for a consideration (sum of money). The coupons for interest are attached to the debentures. You/bearer can claim interest from the Company, when it becomes due.
  • Registered debentures: If you purchase a registered debenture, your name is entered in a register. Interest coupons are sent to you/persons whose name is present in the register.
  • Redeemable debentures: These debentures are redeemed after a point in time.  They are redeemed on expiry of a certain period.
  • Irredeemable debentures: These debentures are not redeemed within the lifetime of a Company. They are payable only on winding up or on Company default.
  • Convertible debentures: Convertible debentures give the holder the right to convert debentures to equity after a certain time.
  • Zero interest debentures: You don’t get interest on zero interest debentures. You are compensated by conversion of the debenture to equity shares after a certain time.
  • First/Second debentures: Interest payments are paid first to first debenture holders. Then, second debenture holders get interest payments.
  • Guaranteed debentures: Banks and Government (third parties) guarantee principal and interest payments.
  • Collateral debentures: A Company may issue debentures in favor of a bank or a financial institution as collateral for loans raised.
  • Non convertible debenture (NCD): NCDs cannot be converted to equity. The investor gets principal + accumulated interest at maturity.

Advantages of debentures:

  • Debentures are a safe investment and offer security to conservative investors.
  • You get interest payments irrespective of whether a Company is making a profit.
  • Raising capital via dividends is less costly.
  • The Company doesn’t need to dilute equity. It can raise long-term finance at lower rates.
  • Companies can expand using money provided by the debenture holders.

Disadvantages of debentures:

  • Companies with fluctuating income must not opt for debentures.
  • A Company pays interest on debentures, irrespective of whether it makes a profit.
  • Debenture holders do not enjoy voting rights.
  • In a recession, Company may not be able to pay debenture interest.
  • Debentures are secured against assets, making it difficult for Companies to raise further loans and advances.

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