by Debentures are financial instruments used by companies to raise debt capital. Unlike shares, which represent ownership, debentures represent a loan from the debenture holder to the company. They are typically issued with a fixed interest rate, known as a coupon rate, which is paid to the debenture holder at regular intervals. Debentures are often secured by the company’s assets or are issued on an unsecured basis.
Meaning of Debentures
Debenture is a written instrument issued by a company acknowledging a debt and containing an undertaking to repay a specified sum of money after a fixed period along with interest at a predetermined rate. It is one of the most important long-term sources of finance for companies. Debentures enable companies to raise funds without diluting ownership, as debenture holders are creditors and not owners of the company.
Debentures may be secured or unsecured and may carry a fixed or floating charge on the assets of the company. The company is legally bound to pay interest on debentures whether it earns profits or not. In corporate accounting, debentures are treated as long-term liabilities and shown on the liabilities side of the balance sheet.
Definitions of Debentures
- According to Section 2(30) of the Companies Act, 2013
A debenture includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.
This definition clearly indicates that debentures are instruments acknowledging debt and may or may not be secured by the company’s assets.
- According to Thomas Evelyn,
“A debenture is a document under the company’s seal which provides for the repayment of a principal sum and interest thereon at regular intervals.”
This definition emphasizes the legal nature of debentures and the obligation to pay interest and principal.
- According to L.H. Haney,
“A debenture is an instrument issued by the company acknowledging its debt to its holder.”
This definition highlights the creditor relationship between the company and the debenture holder.
Characteristics of Debentures:
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Fixed Interest Rate
Debentures typically offer a fixed interest rate, known as the coupon rate, which is paid to debenture holders periodically (e.g., annually or semi-annually). This fixed return provides investors with predictable income.
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Maturity Date
Debentures have a specified maturity date when the principal amount (the amount borrowed) is repaid to the debenture holders. The term can vary from a few years to several decades, depending on the company’s needs and the terms of the debenture issue.
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Secured or Unsecured
Debentures can be either secured or unsecured. Secured debentures are backed by the company’s assets, providing additional security to investors. In case of default, the assets can be liquidated to repay the debt. Unsecured debentures, also known as naked debentures, are not backed by specific assets and rely solely on the company’s creditworthiness.
- Convertibility
Some debentures are convertible, meaning they can be converted into equity shares of the company at a predetermined conversion ratio and time. This feature offers potential upside if the company’s shares appreciate in value.
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Priority in Payment
In the event of liquidation, debenture holders have a higher priority over equity shareholders in receiving payment. Secured debenture holders are paid before unsecured debenture holders and equity shareholders.
- Transferability
Debentures are generally transferable, meaning they can be bought and sold in secondary markets. This provides liquidity and allows investors to trade debentures before their maturity.
- Non-Voting
Debenture holders do not have voting rights in the company. Unlike shareholders, they do not participate in company decisions or have a say in corporate governance.
- Covenants
Debenture agreements often include covenants or conditions that the issuing company must adhere to. These covenants can include maintaining certain financial ratios, restricting additional debt, or ensuring timely payment of interest and principal.
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Interest Payment Frequency
Debentures often have a defined schedule for interest payments, which can be annual, semi-annual, or quarterly. This regularity provides investors with a steady income stream.
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Callable or Redeemable
Some debentures come with a callable feature, allowing the issuing company to redeem them before the maturity date at a predetermined price. This can be advantageous for the company if interest rates decline, as it can refinance the debt at a lower cost.
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Redeemable or Perpetual
Debentures can be redeemable, meaning they are repaid at a set date, or perpetual, meaning they have no fixed maturity date and may remain outstanding indefinitely. Perpetual debentures often offer a higher interest rate due to their indefinite term.
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Regulatory Compliance
Debentures are subject to regulatory frameworks and disclosure requirements, ensuring that companies provide transparent information about their financial status and the terms of the debenture issue. This regulation protects investors by maintaining market integrity and accountability.
Methods of Borrowing Debentures:
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Public Issue
Companies can issue debentures to the general public through a public offering. This method involves preparing a detailed prospectus, which provides information about the company, the terms of the debenture, and the associated risks. The debentures are sold to a wide range of investors, including individuals and institutional investors, through a formal process managed by underwriters or investment banks.
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Private Placement
Debentures can be issued to a select group of investors, such as institutional investors or high-net-worth individuals, through private placement. This method does not require a public offering or prospectus and is typically faster and less expensive. Private placements allow for more flexible terms and conditions tailored to the specific needs of the investors.
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Convertible Debentures
Companies may issue convertible debentures, which can be converted into equity shares of the company at a predetermined conversion ratio and date. This method attracts investors who seek potential upside from equity conversion while providing the company with long-term financing. Convertible debentures combine debt with the option for equity participation.
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Non-Convertible Debentures (NCDs)
Non-convertible debentures are purely debt instruments that cannot be converted into equity. They provide fixed interest returns and are repaid at maturity. NCDs are a common method for companies to raise funds without diluting ownership, and they often offer higher interest rates compared to convertible debentures due to their fixed nature.
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Debenture Stock
Debenture stock is a method where the company issues debentures in the form of stock certificates. This method divides the principal amount into smaller units or stocks, making it easier to manage and trade. Debenture stock can be publicly traded or privately held, depending on the company’s needs and regulatory requirements.
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Medium-Term Notes (MTNs)
Medium-Term Notes are a type of debenture issued for a period typically ranging from one to ten years. MTNs offer flexible terms and can be issued in multiple tranches with varying maturities, interest rates, and conditions. They provide companies with the ability to raise capital in stages as needed.
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Private Debt Placements
In private debt placements, companies negotiate directly with lenders or investors to issue debentures. This method involves customized terms and conditions, and the debentures are often not traded on public markets. It offers confidentiality and tailored financing solutions.
- Securitization
Securitization involves pooling various debt instruments, including debentures, and creating securities backed by these assets. These securities are then sold to investors. This method allows companies to access a broader investor base and provides liquidity by converting debentures into tradable securities.
Types of Debentures
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Convertible Debentures
Convertible debentures can be converted into equity shares of the issuing company at a predetermined conversion ratio and within a specified time frame. This feature allows investors to benefit from potential equity upside if the company’s stock performs well.
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Non-Convertible Debentures (NCDs)
Non-convertible debentures cannot be converted into equity shares. They are purely debt instruments offering fixed interest payments and principal repayment upon maturity. NCDs typically offer higher interest rates compared to convertible debentures due to their lack of conversion feature.
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Secured Debentures
Secured debentures are backed by the company’s assets, providing security to debenture holders. In the event of default or liquidation, secured debenture holders have a claim on the pledged assets before other creditors or shareholders.
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Unsecured Debentures
Unsecured debentures, also known as naked debentures, are not backed by any specific assets. They rely on the issuing company’s creditworthiness. In case of default, unsecured debenture holders are repaid after secured creditors have been satisfied.
- Redeemable Debentures
Redeemable debentures are issued with a specified maturity date, at which point the principal amount is repaid to the debenture holders. They may be redeemed at a fixed date or at the company’s option, subject to terms outlined in the debenture agreement.
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Perpetual Debentures
Perpetual debentures have no fixed maturity date and remain outstanding indefinitely. The issuing company pays interest for as long as the debenture remains outstanding. Perpetual debentures often offer higher interest rates to compensate for their indefinite term.
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Debenture Stock
Debenture stock is a type of debenture where the principal is split into multiple units or stock. It functions similarly to debentures but is structured to facilitate easier trading and management of debt.
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Subordinated Debentures
Subordinated debentures, also known as junior debentures, rank below other forms of debt in terms of repayment priority in the event of liquidation. They offer higher interest rates to compensate for their lower repayment priority.
Advantages of Debentures
- No Dilution of Ownership
Issue of debentures does not dilute the ownership or control of existing shareholders. Debenture holders are creditors and do not enjoy voting rights or participation in management. Hence, promoters and existing shareholders can retain full control over company affairs while raising large funds. This makes debentures an attractive financing option for companies that wish to expand operations without sharing ownership or decision-making authority.
- Fixed and Certain Cost of Capital
Debentures carry a fixed rate of interest, which is payable irrespective of profits. This enables the company to estimate its financial commitments accurately. Unlike dividends on shares, interest on debentures does not fluctuate with profits, providing certainty in financial planning and budgeting. This predictable cost structure helps companies manage cash flows efficiently and maintain financial discipline.
- Tax Benefit on Interest
Interest paid on debentures is treated as a business expense and is deductible while calculating taxable profits. This reduces the overall tax liability of the company. As a result, the effective cost of debenture finance becomes lower compared to equity shares, where dividends are paid out of post-tax profits. This tax advantage encourages companies to use debentures as a source of long-term finance.
- Flexibility in Capital Structure
Debentures provide flexibility in designing a suitable capital structure. Companies can issue debentures for a specific period and redeem them after maturity. This helps in adjusting the debt-equity ratio according to business needs. Debentures can be secured, unsecured, convertible, or redeemable, allowing management to choose the most appropriate form of financing.
- Useful During Inflation
During inflationary periods, debentures prove advantageous because the company repays the principal amount with money that has lower purchasing power. The real burden of repayment decreases over time. Fixed interest payments also become relatively cheaper in real terms. Thus, debentures help companies benefit from inflation while meeting long-term financing requirements.
- Suitable for Trading on Equity
Debentures help companies achieve trading on equity, where borrowed funds are used to increase returns to equity shareholders. If the company earns a rate of return higher than the debenture interest rate, equity shareholders benefit through higher earnings per share. This financial leverage enhances profitability and shareholder wealth when managed efficiently.
- Safety to Investors
Debentures are generally considered a safer investment because they offer fixed interest and priority in repayment at the time of liquidation. Secured debentures are backed by company assets, providing additional safety to investors. This makes debentures attractive to conservative investors who prefer stable income with relatively low risk compared to equity shares.
- Easy to Raise Large Funds
Companies can raise large amounts of funds through debentures, especially when they have good creditworthiness. Institutional investors such as banks, insurance companies, and financial institutions prefer investing in debentures. This enables companies to meet long-term capital requirements for expansion, modernization, or diversification without difficulty.
Disadvantages of Debentures
- Fixed Financial Burden
Interest on debentures must be paid regularly, regardless of whether the company earns profits or suffers losses. This creates a fixed financial burden on the company. During periods of low income or losses, payment of interest can strain cash flows and adversely affect the financial stability of the company.
- Risk of Over-Capitalisation
Excessive reliance on debentures can lead to over-capitalisation. Heavy interest obligations may reduce net profits available to shareholders. If earnings do not increase proportionately, the company may face financial difficulties. Over-use of debenture finance increases fixed costs and can negatively impact the long-term profitability of the business.
- Compulsory Repayment
Debentures are generally issued for a fixed period and must be redeemed on maturity. The obligation to repay principal creates pressure on company finances. If sufficient funds are not available at the time of redemption, the company may be forced to raise additional capital or sell assets, affecting its financial position.
- No Benefit of Profit Sharing
Debenture holders receive only fixed interest and do not share in the profits of the company. From the company’s perspective, even if profits are high, interest payments remain unchanged. This means the company cannot reduce interest costs during profitable periods, limiting flexibility in profit distribution.
- Restriction through Security
Secured debentures create a charge on company assets, restricting their use for future borrowing. Once assets are mortgaged, the company’s ability to raise additional loans becomes limited. This reduces financial flexibility and may affect expansion or emergency funding requirements.
- Increased Financial Risk
Debentures increase the financial risk of the company due to fixed interest commitments. High leverage increases the possibility of insolvency during adverse business conditions. If earnings decline, meeting interest and repayment obligations becomes difficult, exposing the company to the risk of liquidation.
- No Voting Rights Support
Debenture holders do not participate in management and do not provide managerial support. Unlike shareholders, they do not contribute ideas or strategic guidance. The absence of such involvement may deprive the company of valuable suggestions and expertise that active shareholders might otherwise provide.
- Impact on Credit Rating
Excessive debenture financing may adversely affect the company’s credit rating. High debt levels signal higher risk to lenders and investors. This may increase the cost of future borrowings or reduce investor confidence, making it difficult for the company to raise additional funds when needed.
