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Debentures: Definition, Features, Types, Advantages & Risks

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There are many debt instruments for investors to invest in the market, including a debenture. There is, however, one crucial difference between a debenture and other debt instruments available; a debenture does not have the backing of a collateral. The main factor in which traders should pick a debenture in such a case is keeping the issuer’s creditworthiness and reputation in mind. Debentures are also very often used by both the government and various corporations to raise capital or funds.

Understand the Meaning of Debentures?  

Most debentures are very similar to bonds concerning payment of the regular interest amount and can be categorised as an indenture, that both government and corporations can issue. To clarify, an indenture is a contract between bond issuers and holders which is legally binding.

The indenture has all the details about a bond or debenture. This includes information about the maturity date, the interest payment timings, how the interest is calculated, etc. 

When debentures are issued by governments, they can be categorised as long-term investments with maturities of more than 10 years. Debentures issued by governments are usually considered less risky as they are backed by the reputation of the government issuing them. 

Debentures issued by corporations are also long-term loans but are considered more risky since the only backing they have is the creditworthiness and financial history of the underlying company.

Types of Debentures 

There are six types of debentures:

  1. Registered:

    These are the types of debentures that are registered to the issuer. Any further transfer or trades of these debentures that lead to changes in their ownership are then alerted to the issuer through a clearing facility. This helps them pay interest to the correct bondholder.

  2. Bearer

    A bearer debenture is the opposite of a registered debenture where the debenture is not registered with the issuer and the ‘bearer’ of the debenture is entitled to interest simply because they hold the bond.

  3. Redeemable

    Debentures that are transparent about the exact terms and date by which the issuer of the bond must repay their debt in full are known as redeemable debentures. 

  4. Irredeemable

    Irredeemable, also known as non-redeemable or perpetual debentures do not hold the issuer liable to repay in full by a certain date. 

  5. Convertible

    These debentures can be considered a hybrid financial instrument as they come with the benefit of both equity and debt.  This is because convertible debentures, after a specific time, get converted into equity shares of the corporation that issued them. These are more attractive to those investors who feel that the company's stock will rise in the long term. This conversion to equity however comes at an additional cost as the interest rate of these debt instruments are usually very low.

  6. Non-Convertible

    As the name suggests, nonconvertible debentures, cannot be converted into equity of the issuing company. However, because of this rigidity, these debentures do offer a higher interest rate to their investors when compared to convertible debentures.

How Do Debentures Work?

Here’s a detailed look at the working of debentures:

  1. Issuance

    • The interest rate or coupon rate and the maturity date are specificed to investors when companies issue debentures

    • By issuing a debenture, companies can raise significant funds from investors without giving up ownership. 

    • All the details about the debentures along with the T&Cs are listed in a prospectus. 

  2. Interest Payments

    • Companies pay debenture holders interest payments annually or semi-annually.

    • This interest rate is usually fixed and provides a predictable and steady income to investors. 

  3. Principal Repayment

    • The issuing company repays the principal amount to the holders when the debentures mature

    • Investors get back their initial investment, making debentures less risky investments than equities

Features of a Debentures  

Some of the main features of debentures are listed below:

  • Interest Rate

    • The coupon rate is the rate of interest that the company will pay the debenture holder or investor and can either be fixed or floating. 

    • A floating rate might be tied to a benchmark and can change if this benchmark changes.

  • Credit Rating

    • The company's credit rating has an impact on the interest rate investors receive. 

    • Credit ratings help investors get an overview of the risks involved in investing with a particular company or government

    • These credit ratings are letter grades ranging from AAA for excellent rating to the lowest rating of C and D. 

    • Debt instruments receiving BB and lower are categorized as speculative grade.

  • Maturity Date

    • The maturity date indicates when the company needs to pay back the debenture holders. 

Advantages and Disadvantages of Debentures 

The advantages and disadvantages of debentures are listed below:

  • Advantages:

    • Investors receive regular interest payments with a steady interest 

    • If investors invest in convertible debenture, they can eventually convert them to equity shares, leading to holding a portion of the company’s ownership

    • If the issuing company goes bankrupt, the debenture gets paid before common stock shareholders.

  • Disadvantages

    • Debentures having a fixed interest rate can face risk in situations where the market interest rate is rising.

    • It is important to consider the issuer’s creditworthiness since otherwise, the chances of default risk can be high

    • If in case the rate of interest does not keep up with the rate of inflation, investors may face inflationary risks.

Factors to Consider Before Investing in Debentures  

When considering investing in debentures, below is a list of some of the factors that need to be kept in mind. 

  • Trading Debentures
  • Debentures are traded in the secondary market 
  • Investors can buy/sell them after they have been issued 
  • Debenture trading is similar to equity trading
  • However, debenture trading also has lower volatility and less exposure to market risk.
  • Regulatory Framework Involved
  • Regulations like SEBI guidelines and provisions of the Companies Act, monitor the issuing of debentures 
  • This ensures transparency and protects the investor. 
  • The Companies Act also lists the requirement for a debenture redemption reserve.

How Debentures are Structured? 

Below is a detailed account of how debentures are structured:

  1. Debentures are used by corporations to raise capital through potential investors. 

  2. The element of the “Indenture,” which is a legal document, encompasses all the terms and conditions of a debenture

  3. The indenture can also hold details about whether or not debenture holders have the right to convert their holdings into equity shares of the company.

  4. The interest rate is another important component of the debenture as it points towards the annual returns an investor gets as a top-off to the principal investment till the debenture matures

  5. The maturity date of a debenture lists the exact date on which the issues need to repay the principal amount to the investors providing clarity to them.

  6. Some debentures are also backed by collateral in the form of specific assets, which can be liquidated to repay the investors, protecting them from default or financial distress

How Debentures are Different From Bonds, Shares & Loans 

Listed below are the differences between debentures, bonds, shares and loans

Aspect

Debentures

Bonds

Shares

Loans

Investment Type

Debt instruments usually with a fixed interest rate issued by a company or government 

Debt instruments with fixed interest payments issued by governments or corporations, 

Shares represent a share of a company’s assets and profits and indicate part ownership in it

A sum borrowed which the borrower is obliged to repay along with interest.

Returns

Repayment of the principal amount along with the Interest payments received

Repayment of the principal amount along with the Interest payments received

Returns are received in the form of dividends if and when the company profits.

Repayment of the principal amount along with the Interest payments given

Security

Usually secured by a charge on its assets.

Usually backed by a repayment guarantee and sometimes secured/ unsecured by the issuer’s assets 

No repayment obligation.

Lenders usually rely on a borrower’s creditworthiness.

Risk

Less risky than equities but more than loans.

Government bonds are considered less risky than corporate bonds.

Quite risky because of the constant market fluctuations

Depends on the borrower’s creditworthiness

Ownership

Holder has no ownership stake

Holder has no ownership stake

Investors have ownership and voting rights

No ownership stake 

Interest Rate

Usually fixed interest rate.

Usually fixed interest rate.

Interest rate not valid.

Fixed interest rates are usually pre-set by the lender

Market Trade

Market trading is possible

Market trading is possible

Traded in the stock market.

No trading involved

Priority

Higher priority for debenture holders during liquidation compared to shareholders.

Higher priority for bondholders during liquidation compared to shareholders.

Very low on the priority list where liquidation is concerned

Lender has first right to payment

Risks Involved in Investing In Debentures  

Some of the risks involved in investing in debentures are listed below:

  1. While debentures are comparatively a low-risk investment option, they do hold a few risks without a doubt

  2. These include credit risk where there is a risk of default by the issuing company 

  3. Even though debentures usually have a fixed interest rate, any changes will affect debenture value. 

  4. With inflation risk comes the fear of the value of the investment eroding over time. 

  5. Investors also need to consider the liquidity risk in debentures in case they are not able to sell when needed.

Conclusion 

Here’s a summation of everything you need to know about debentures:

  1. Debentures are debt instruments for investors to invest in the market, without having the backing of a collateral. 

  2. Debentures are usually issued by governments or companies to raise capital

  3. The investment risk depends totally on the issuer’s creditworthiness and reputation. 

  4. Debentures also come with tax concession and flexibility

  5. Before investing, investors need to keep many factors in mind to avoid potential losses.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

Frequently Asked Questions

What are debentures used for?

Answer Field

A debenture bond is very often used by both the government and various corporations to raise capital or funds

Is debenture a loan?

Answer Field

A debenture bond is a debt instrument for investors that does not have the backing of collateral.

How does a debenture differ from a bond?

Answer Field

Debentures are usually not secured by any physical assets by the issuers whereas bonds are secured by physical assets by the issuer

Why do companies issue debentures?

Answer Field

Companies issues use debentures to raise capital for their business developments

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