What is a Debenture

A debenture is a loan without collateral, relying on the issuer’s reputation to repay.
What is a Debenture
3 mins
06 December 2023

Key takeaways

  • Debentures are debt instruments issued by companies or government entities to raise capital.
  • Corporations and governments often issue debentures as a common means to raise capital.
  • Debenture holders are company creditors, getting periodic interest and the principal back at maturity.
  • Debentures rely solely on the issuer's creditworthiness and reputation, lacking specific collateral.

A debenture is a type of loan, or a long-term debt instrument issued by a company or organisation to raise funds from the public or institutional investors. It is essentially a form of loan that investors provide to the issuer, typically a corporation, or government entity. In return, the issuer promises to repay the principal amount along with periodic interest payments at a predetermined rate.

What are the key features of debentures?

Here are certain features of debentures you should know:

  1. Fixed maturity date: Debentures have a specific maturity date, indicating when the issuer must repay the principal amount to the debenture holders. This date is predetermined and provides clarity on when investors can expect to receive their initial investment back.
  2. Interest payments: Debentures typically pay periodic interest to investors. This interest can be fixed, meaning it remains constant throughout the debenture's life, or it can be variable, in which case it fluctuates based on market conditions or a predefined formula.
  3. No ownership rights: Debenture holders are creditors of the issuer, not owners. They do not have any ownership or voting rights in the issuing company or organisation. Their relationship with the entity is that of a lender.
  4. Secured or unsecured: Debentures can be secured or unsecured. Secured debentures are backed by the issuer's assets, which serve as collateral, providing a level of security for the principal amount and interest payments. Unsecured debentures (also known as "unsecured debentures" or "debenture stock") lack collateral and are riskier but often offer higher interest rates to compensate for the increased risk.
  5. Transferability: Debentures are generally transferable, meaning investors can sell, trade, or transfer them to other parties in the secondary market. This feature enhances liquidity and allows investors to exit their investments if needed.
  6. Various types: Debentures come in various forms, each with unique characteristics. These include convertible debentures, non-convertible debentures, redeemable debentures, and irredeemable debentures. The specific type of debenture affects its terms and conditions, such as conversion rights, redemption provisions, and interest rates.

Additional read: What is Share Market

What are the different types of debentures?

Let us learn more about the different types of debentures:

1. Convertible debenture:

  • A convertible debenture is a type of debt instrument that provides the holder with the option to convert the debenture into equity shares of the issuing company after a specified period.
  • This conversion feature allows investors to benefit from potential capital appreciation if the company's stock price rises, thereby transitioning from being creditors (debt holders) to shareholders.

2. Non-convertible debenture (NCD):

  • Non-convertible debentures are debt instruments that cannot be converted into equity shares. They remain as fixed-income securities throughout their tenure.
  • NCDs offer investors regular interest payments at a predetermined interest rate until the maturity date, providing a predictable income stream.

3. Registered debenture:

  • A registered debenture is a debenture for which the issuer maintains a register of debenture holders. These debentures are linked to specific investors, and the issuer has a record of the holders' names and contact information.
  • Registered debentures provide a level of security for investors, as they can be easily traced in case of loss or theft.

4. Unregistered debenture:

  • Unregistered debentures, in contrast to registered debentures, do not have a specific record of individual debenture holders. They are considered bearer debentures.
  • Unregistered debentures can be transferred more easily, as they do not require a formal transfer of ownership, making them more convenient for trading in the secondary market.

5. Redeemable debenture:

  • Redeemable debentures are debentures that come with a specific maturity date. The issuer is obligated to repurchase them from debenture holders at face value upon maturity.
  • Investors receive both periodic interest payments and the return of the principal amount upon maturity, which provides clarity on when the investment will be repaid.

6. Irredeemable debenture (perpetual debenture):

  • Irredeemable debentures, also known as perpetual debentures, do not have a fixed maturity date. They continue indefinitely, and the issuer has no obligation to repurchase them.
  • Investors receive periodic interest payments, and the principal amount remains invested, with no specified date for redemption. These debentures offer a perpetual income stream.

Each type of debenture serves different investment and financing purposes, catering to the needs of both issuers and investors with varying financial goals and risk preferences.

Difference between debentures and shares

Debentures and shares are both financial instruments used by companies to raise capital, but they differ in several key aspects:

1. Nature:

  • Debentures: Debentures are debt instruments issued by companies to raise funds. Holders of debentures are creditors of the company and have a fixed claim on interest payments and repayment of principal.
  • Shares: Shares represent ownership in a company. Shareholders are part owners and have an equity stake in the company. They participate in the company's profits through dividends and may exercise voting rights.

2. Ownership and voting rights:

  • Debentures: Debenture holders do not have ownership rights or voting privileges in the company. They are lenders and receive fixed interest payments.
  • Shares: Shareholders are owners of the company and have voting rights. They can participate in key decisions, such as electing the board of directors.

3. Return on investment:

  • Debentures: Debenture holders receive fixed interest payments, and the principal amount is repaid at maturity. The return on investment is predetermined.
  • Shares: Shareholders' returns are variable and dependent on the company's profitability. Returns come in the form of dividends and capital appreciation.

4. Risk and reward:

  • Debentures: Debenture holders bear lower risk compared to shareholders. They have a fixed claim on interest payments and repayment of principal.
  • Shares: Shareholders assume higher risk as returns are tied to the company's performance. They may benefit from capital appreciation, but there is no guaranteed return.

Additional read: What Does it Mean by Fear and Greed Index

Differences between debentures and bonds

Debentures and bonds are both types of debt instruments used by companies and governments to raise capital, but they differ in several key aspects:

1. Definition:

  • Debentures: Debentures are unsecured debt instruments issued by companies to raise funds. They represent a form of long-term borrowing where the issuer agrees to pay periodic interest and return the principal amount at maturity.
  • Bonds: Bonds are debt securities that can be either secured or unsecured, issued by governments, municipalities, or corporations. Bonds represent a promise to repay the principal along with periodic interest payments.

2. Issuer type:

  • Debentures: Primarily issued by corporations in the private sector to raise capital.
  • Bonds: Issued by a broader range of entities, including governments, municipalities, and corporations.

3. Term usage:

  • Debentures: The term "debenture" is often used for corporate debt instruments.
  • Bonds: The term "bonds" is more generic and can refer to debt instruments issued by various entities.

4. Conversion features:

  • Debentures: Debentures typically do not have conversion features, meaning they cannot be converted into equity shares of the issuing company.
  • Bonds: Some bonds may have convertible features, allowing bondholders to convert their bonds into equity shares under specific conditions.

5. Risk and return:

  • Debentures: Generally considered to carry higher risk compared to bonds, especially unsecured debentures. The return is typically in the form of fixed interest payments.
  • Bonds: May have varying levels of risk depending on factors like the issuer's credit rating. Returns can be fixed or variable.

6. Credit rating:

  • Debentures: Issuers of debentures are subject to credit ratings, which impact the interest rate they must offer to attract investors.
  • Bonds: Credit ratings are also applicable to bonds, influencing the interest rate and the perceived credit risk.

Difference between a debenture and a loan

Let’s explore the difference between a debenture and a loan:

1. Debenture:

  • A debenture is a type of debt instrument issued by companies to raise capital.
  • It is not secured by physical assets or collateral.
  • Debentures promise to pay interest and principal to the debenture holders.
  • Companies issue debentures to investors, and these investors become creditors of the company.
  • Debentures are typically used for long-term financing.

2. Loan:

  • A loan is a sum of money borrowed from a lender.
  • It requires repayment with interest over a specified period.
  • Loans can be secured or unsecured:
    • Secured loan: Backed by collateral (such as property or assets). If the borrower defaults, the lender can seize the collateral.
    • Unsecured loan: No collateral is required, but interest rates may be higher.
  • Banks and financial institutions typically issue loans to individuals and businesses.

In summary, while both debentures and loans involve borrowing money, the key distinction lies in security: debentures lack collateral, whereas loans can be secured or unsecured.

What are the advantages of debentures?

Investing in debentures offers several advantages:

  1. Regular income: Debenture holders receive regular interest payments, ensuring a predictable income stream.
  2. Safety of principal: Secured debentures are backed by the issuer's assets, providing a level of security for the principal amount.
  3. Diversification: Debentures allow investors to diversify their portfolios beyond equities, reducing overall risk.
  4. Liquidity: Most debentures are tradable in secondary markets, providing liquidity to investors.
  5. Fixed returns: Fixed interest rates on debentures offer stability in a fluctuating market.

Additional read: Difference between primary and secondary market

What are the disadvantages of debentures?

Despite their advantages, debentures also come with certain disadvantages:

  1. Interest rate risk: If interest rates in the market rise, the fixed interest payments on debentures may become less attractive.
  2. Credit risk: Unsecured debentures carry a higher risk of default by the issuer, leading to potential loss of principal.
  3. Market risk: Debenture prices can fluctuate in response to market conditions, affecting their market value.
  4. Lack of ownership: Debenture holders have no ownership or voting rights in the issuing company.

What are the risk factors while investing in debentures?

Investors should be aware of potential risk factors when considering debenture investments:

  1. Credit risk: Assess the issuer's creditworthiness, as default can lead to losses.
  2. Interest rate risk: Understand the sensitivity of debenture prices to changes in interest rates.
  3. Liquidity risk: Some debentures may have limited liquidity in secondary markets.
  4. Market risk: Be prepared for price fluctuations in response to market conditions.

Conclusion

In conclusion, debentures offer different options for companies to raise money and for people to invest. You can choose between debentures that may convert into company shares or those that simply provide a regular fixed income. Whether a company needs funds for growth, or an investor wants a steady income, debentures can be a good choice. It is important for everyone to understand the different types of debentures and their features, as well as the risks involved.

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Frequently asked questions

What is a debenture with an example?

A debenture is a long-term debt instrument issued by a company to raise capital. For example, if Company X issues Rs. 1,00,00,000 worth of 5% convertible debentures with a maturity of 5 years, investors purchasing these debentures will receive Rs. 5,00,000 in annual interest payments and have the option to convert them into Company X's equity shares.

What are debentures used for?

Debentures are used by companies and organisations to raise funds for various purposes, including financing expansion, research and development, debt refinancing, and working capital.

How do debentures work?

Investors purchase debentures, becoming creditors of the issuing company. The company repays the principal and interest at specified intervals, and the debentures can be traded in secondary markets for liquidity.