What is Debenture: Features, Types, Advantages, Disadvantages & Risk Factors Involved

Every company requires capital to operate their business. Several companies issue shares or corporate bonds in public to raise funds in the form of debentures.

This blog focuses on what are debentures and other associated details. So keep reading to know all about them.

Debentures are the written debt instruments acknowledging the debt under the common seal of the company. They may or may not be secured by collateral. It is a legal contract where the issuer promises to repay the principal as well as the interest amount after the specified period. The certificate mentions the investment or principal amount, interest payables and payment schedules.

An investor gets the interest and principal payment after the maturity of the tenure. Since debentures are unsecured by collateral, the repayment relies on issuers' creditworthiness. However, sometimes companies issue these debt instruments against mortgaging an asset. In this regard, companies have to liquidate their mortgaged assets to repay the debt to creditors.

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Listed below are a few features of debenture, take a look:

1. Written Promise

A company issues a debenture as a written promise to a holder specifying the money it owes to the latter.

2. Repayment Tenure

A debenture is a debt instrument that specifies the maturity of the repayment tenure within which an issuing company needs to repay the interest and principal amount to the investor.

3. Face Value

A debenture may carry a face value of ₹ 100 or multiples of the same amount.

4. Fixed Interest Rate

An interest rate of a debenture is fixed, which an issuing company can pay to the holder either yearly or half-yearly. However, an interest rate may differ with each company, type of business and present market conditions.

5. Redeemable Debt Instrument

A redemption means repayment of debt to a holder. A company can redeem debentures at par, premium or discount.

6. No Right to Voting

A debenture holder does not enjoy voting rights in an issuing company's general meetings unless it permits him or her to express an opinion in special circumstances.

7. Parties Involved in Debenture

There are three parties involved in a debenture -

• A company that issues debenture and borrows money through it. 
• Another is a trustee, through which a company communicates with a holder. The company draws an agreement between a holder and trustee. This is known as a 'Trust Deed', which specifies obligations of a company, holder's rights and other necessary details.
• Finally, a debenture holder is an individual who gives a loan to the company. In return, he or she gets a debenture certificate as proof of participation.

8. Listing

A debenture is required to be listed at least in one stock exchange.

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A company can borrow funds through different types of debentures depending on its needs and objectives. Here are the following types of debentures that a company can use to raise funds:

1. Secured Debenture

These types of debentures are secured against a company's assets. This implies that if the company fails to repay debt due to insufficient funds, it will have to sell its mortgaged assets to repay the dues. There may be a fixed charge against particular assets or floating charge against a company's assets.

2. Unsecured Debentures

Unsecured debentures are not secured by any collateral. This implies that there are no fixed or floating charges against an issuing company's assets. However, Indian companies do not issue these debentures.

3. Convertible Debenture

Under a convertible debenture, the holder enjoys the right to convert his or her debenture into a company's equity share. The company provides information about the holder's rights, conversion date and additional terms and conditions during the time of issuance.

There are further three types of convertible debentures –

• Partly Convertible Debentures - The company can partly change debentures into equity shares. It determines the conversion date and ratio at the time of issuing this debt instrument. The holder exercises the right of both the creditor and the shareholder in the company.
• Optionally Convertible Debentures - In this, the holder enjoys an option whether they wish to change their debenture into equity shares or not at a rate determined by the issuer at a specified date, during the time of issuance of the debt instrument.
• Fully Convertible Debentures - As the name suggests, the company that issues debentures can fully change them into equity shares. Like partly convertible debentures, the issuer determines the conversion date and rate at the time of issuance to be convertible at a specified date. After conversion, the holder holds similar rights as a shareholder in the issuing company.

4. Non-Convertible Debentures

A non-convertible debenture does not entitle a holder to convert his or her debentures into an equity share. This debt instrument has a higher interest rate than its regular counterparts.

5. Redeemable Debentures

These debentures are payable at the maturity of the tenure in instalments or lump sums over a particular time. These debentures are redeemable at a premium, par or discount.

6. Irredeemable Debentures

There is no particular date fixed to repay the debt under these debentures. It is redeemable when the issuer liquidates its shares or after a long interval.

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Here are the following advantages of debentures that both an issuing company and the debenture holder can enjoy:

• Debentures are debt instruments through which a company borrows money without diluting the equity.
• The interest payable towards debentures is charged against the issuing company's profit. The expenditure on the interest payment qualifies for a tax deduction that helps to reduce a company's taxable income.
• These debt instruments are liquid assets, and a company can trade these on the stock exchange.
• Unlike other sources of borrowing, debentures are comparatively cheaper due to a lower interest rate than other debt instruments.
• The holder has a lower risk of facing default in repayment by the borrower since there is an assurance of receiving the interest payment even if the company experiences financial loss.
• Borrowing funds through debentures is beneficial even during inflation due to their fixed interest rates.

Go through the following disadvantages of debentures:

• The interest payment is a financial burden on a company because it must pay the interest dues to the debenture holders even if it faces monetary loss.
• Issuing debentures assists a company in trading on equity. However, such debt instruments make it reliant on debt. Often, an imbalanced debt-equity ratio hampers the financial viability of a company.
• Redeeming debentures causes a huge cash outflow which may imbalance a company's liquidity.
• Debentures can be expensive during a depression when profits decrease, but the interest rate remains fixed.

Investors can face the following few risks while investing in debentures:

• Risk of Fixed Interest Rate

Debentures have a fixed interest rate. Therefore, investors will get the expected interest amount irrespective of the inflationary trend that causes a hike in the interest rate. In that case, they may lose a better opportunity to receive higher returns on other debt instruments.

• Risk of Repayment Default

Several companies that issue debentures often do not hold credit ratings from trusted credit agencies. Therefore, investors may find it challenging to gauge a company's financial viability. This makes investors more vulnerable to facing the risk of repayment default by a company.

• Risk of Liquidity

An issuing company allows debenture holders to access their investment capital only in special situations, making it an illiquid investment.

Therefore, before investing in such a debt instrument, keep all these pointers in mind to avoid hassles later.

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