Meaning of Debenture: A debenture is a financial instrument or document issued by the company acknowledging a debt. The company takes money from the public to fulfill its needs and issues them debentures. It has terms of repayment of principal and payment of interest at a rate specified at the time of issue. The persons holding a debenture are called debenture holders or creditors of the company.
Features
- The debentures holders get a fixed rate of interest at regular intervals, as mentioned in the document at the time of issue.
- The interest is tax-deductible, i.e., the tax is calculated after deducting the interest from the profit.
- The debenture holder does not have any voting rights. He/She does not have the right to participate in the management of the company.
- It creates a charge on the assets of the company, i.e., when the company issuing debentures, it has to mortgage its fixed assets.
- The interest on debenture is payable even if there is a loss.
Merits
- These are good investment options if you are looking for a fixed and regular income.
- The Rate of interest you get on debentures is higher than the interest rate you get in a Bank FD.
- It is a safer investment because you have given the money for a fixed time period, and after maturity, you will get back your money and during these periods, you will get regular fixed interest on your amount.
- There are a majority of debentures that are listed on the stock exchanges. You can sell the debentures on the exchange.
Demerits
- There are no voting rights for the debenture holders.
- It has very low liquidity on the stock exchange and hence not easy to exit.
- Even if you invest in debentures based on rating agencies’ credit ratings, the credit rating can change quickly for some companies. For example, in the recent case of IL&FS, it was AAA-rated security, but in weeks or days, it was downgraded by rating agencies to very low ratings, and investors lost money at that time.
- In the case of Unsecured debentures, due to their higher returns, there is a chance of default risk.
Types of Debentures
The debentures are broadly classified into the following types:
(i) On the basis of Security – Secured debentures and Unsecured debentures
- Secured Debentures– These debentures are much safer as the company put up some assets as collateral while borrowing money from the public and promised to repay the interest and principal at the specified time period. Secured means if the company goes bankrupt or winding up, it will sell such assets and repay the money which they had borrowed from the public.
- Unsecured Debentures– Unsecured means if the company goes bankrupt or winding up, the secured debenture holders will get their money first, then the unsecured debenture holders. Hence, unsecured debentures are riskier than secured debentures and because of such risk, they mostly offer a higher interest rate than the secured ones.
(ii) On the basis of Redemption – Redeemable debentures and Irredeemable debentures
- Redeemable Debentures– These debentures are issued for a limited time period by a company. As soon as the time period is over, the company gives the principal amount and redeems those debentures from the holders.
- Irredeemable Debentures– In this case, the company cannot redeem the debentures until it is winding up. Such debentures are not issued in India.
(iii) On the basis of Transferability or Record – Registered debentures and Bearer debentures
- Registered Debentures– In this case, the details of debenture holders are written on the company’s register. So, they cannot transfer their debentures to anyone unless they got sanctioned by the company’s director and unregistered their names from the record.
- Bearer Debentures– In this case, the debenture holders’ details are not written on any register, and even a company does not have registers. In such a case, the debentures will be transferred only according to the possessions. The persons who possess the certificate will be called the debenture holders, and they will get interests and principal as mentioned in the document.
(iv) On the basis of Coupon rate – Zero coupon rate debentures and Premium debentures
- Zero-Coupon Rate– In this type of debenture, no interest will be paid to the debenture holders. They will buy the debenture at a discounted value, and after maturity, they will receive their money according to its face value. For example, if the FV is Rs 1000, the Discounted Value is Rs 600 and the Period of Maturity is 5 years. The debenture holders can buy the debenture at Rs 600 and after 5 years they will receive Rs 1000.
- Premium Debentures– In this type of debenture also, no interest will be paid to the debenture holders. They will buy the debenture at face value and after maturity, they will receive their money at a premium. For example, if the FV is Rs 1000, the Premium Value is Rs 1500, and the period of maturity is 5 years. The debenture holders can buy the debenture at Rs 1000 and after maturity, they will receive Rs 1500.
(v) On the basis of Convertibility – Convertible debentures and Non-convertible debentures
- Convertible Debentures– These debentures will be converted into shares of the company after a specified time period mentioned in the document at the time of issue. There will be no return of principal and the debenture holders will enjoy a fixed specified interest rate till the conversion.
- Non-convertible Debentures– These debentures will not be converted into shares of the company. The holders of such debentures will enjoy a fixed interest rate up to their maturity and after the maturity, they will get the principal amount.
(vi) On the basis of Surrender- Call option debentures and Put option debentures
- Call option– The call option means the company which has issued the debentures has an option to ask the debenture holders to surrender their debentures before the maturity date. In such a situation, the company will pay back the principal to the debenture holders beforehand. Usually, the companies exercise this option if the interest rates have gone down or the company has enough money to pay back.
For example, suppose it is written in the document that the debenture is callable on or after 5 years and the maturity date is 10 years. In that case, the company can buyback the debentures at a pre-defined price before the maturity date.
- Put option– The put option means the debenture holders have the option to surrender the debenture before the maturity date and get back their principal. They exercise this option only when they urgently need money, or when they feel that the company’s condition will get worse in the future or when the interest rate goes up in the market, and they got lesser interest from debentures.
Also Read: Types of Shares in the Stock Market
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