Detailed Explanation About Debentures

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Do you know what are debentures? you might or might not know, what are debentures. Hopefully, by the end of this blog, you would be able to understand what are debentures and why are they different from bonds.

What’s in it for you?

DEBENTURES

DEBENTURES represent the acknowledgment of the debt by a company. They are creditorship securities that provide funds to the company on a loan basis rather than on a capital basis.

 Furthermore, If you are a debenture holder you will get a payment of interest at fixed rates periodically, and these are coupon payments.

When the given issue period is over, the holders are entitled to redeem their debentures as per terms and conditions.

BONDS are the creditor-ship securities that the government issues and debentures are the securities of private institutions.

These are the long term sources of finance for a company, which is usually 10 years and these are both in the form of secured and unsecured financial instruments. 

Companies prefer to raise funds from this source because of lower rates of interest and comparatively longer dates of payment. 

There is a conversion of these documents into equity shares of the company soon after its maturity.

FEATURES

Firstly, These carry a fixed rate of return thus, there is a guarantee of return.

Secondly ,Their redemption is after the completion of the fixed time interval.

Thirdly, The holders don’t have any voting rights, they don’t participate in the election of the board of directors.

And Finally, the unsecured ones have a backup of the creditworthiness of the company and its name in the market.

DIFFERENCE BETWEEN SHARES AND DEBENTURES

BASISSHARESDEBENTURES
1> Type of capitalShares are a part of the owner’s capital.Debentures are a part of borrowed capital.
2> ReturnThese are paid DIVIDEND on each share held.These are paid a fixed rate of INTEREST on each debenture held
3> Voting rightsA shareholder has voting rights.These don’t have any voting rights
4> Redemption No shares are redeemable until the company continues to exist. (except preference shares)A company can redeem its debentures even before the liquidation of the company.
5> ChargeThese are charged against profit and loss appropriation account.These are charged against profit and loss account.
DIFFERENCE BETWEEN SHARES AND DEBENTURES

SOME MERITS AND LIMITATIONS OF DEBENTURES

pros-and-con
pros and cons of debentures

MERITS → 

1> CONTINUOUS INCOME

  It is a source of continuous income on the principal as there is a payment of a fixed rate of interest periodically.

2> SAFETY OF PRINCIPAL →

These could be preferred by those investors who pay more weightage to the safety of the principal amount.

3> TRADING ON EQUITY

These offer the opportunity to the company to trade on equity and pay a higher rate of dividends to the shareholders.

5> FLEXIBILITY →

  These holders enjoy flexibility as there is the redemption of them whenever the company has surplus funds.

6> TAX BENEFIT  →

Interest paid is charged from the profits of the company due to income tax purposes.

Hence, companies enjoy tax benefits for issuing these.

LIMITATIONS → 

1> NO CONTROL

The holders don’t have voting rights. Issuing these documents doesn’t weaken the share of old shareholders in the company. 

2> IMPACT ON CREDIBILITY → 

Issuing a lot of these may cause damage to the name of a company in the market.

As a result debenture falls under the category of liability for a company.

3> FIXED BURDEN →

 Companies have to pay a fixed rate of interest every year ignoring of profits.

therefore, creates a burden on companies.

TYPES OF DEBENTURES

types of debentures
types of debentures

ON THE BASIS OF CONVERTIBILITY

1>REDEEMABLE  AND IRREDEEMABLE  DEBENTURES 

  • REDEEMABLE  DEBENTURES→  

Here, the company reserves the right of paying off the principal amount on or after a given date.

In this case, the certificate given at the time of buying holds the date of redemption.

Thus, It is the charge of the company to pay back the principal amount to the investors on that day.

  • IRREDEEMABLE DEBENTURES → 

These are also called perpetual debentures. These are the opposite of irredeemable ones.

They don’t have any given redeeming date.

In this case, the investors cannot ask the company for paying back the principal amount till the time of wind up of the company.

Here, the investors receive money at the time of wind up of the company or as per the convenience of the company.

2> FULLY AND PARTLY CONVERTIBLE DEBENTURES 

  • FULLY CONVERTIBLE DEBENTURES→ 

Further convertible ones are of two types,

In this case, after a given period of time get fully converted into shares.

  • PARTLY CONVERTIBLE DEBENTURES→ 

Partly convertible are those which have 2 parts,

1>Convertible, which could be converted to equity after some fixed period of time,

2>Non-convertible part that can be redeemed finally at the expiry.  

ON THE BASIS OF SECURITY

on the basis of security - what are debentures
On the basis of security

1> SECURED AND UNSECURED DEBENTURES

  • SECURED DEBENTURES

These are also called as Mortgage debentures. These are secured by having a charge on some asset of the company.

Indeed, These assets are kept with some trustees.

  • UNSECURED DEBENTURES

These are also called as Naked debentures. These are not secured by any asset.

Therefore they are bought by keeping in mind only the creditworthiness of the company.

2>FIRST MORTGAGED AND SECOND MORTGAGED DEBENTURES

  • FIRST MORTGAGED DEBENTURES
  • SECOND MORTGAGED DEBENTURES

These debenture holders have a secondary share on the assets of the company, in case of not payment of the principal amount by the company.

ON THE BASIS OF TRANSFER ABILITY/ REGISTRATION

1> REGISTERED AND UNREGISTERED DEBENTURES (BEARER) DEBENTURE

  • REGISTERED DEBENTURES 

Registered ones are those in which the investors are registered with the company.

The company has complete details about all the registered debenture holders.

Therefore, interest is credited to the investor’s account.

In this case of the transfer, the company needs to be informed.

If the company is not informed, the interest would be paid to the old investor of the company.

  • UNREGISTERED DEBENTURES

        Unregistered are those where the person who has the physical debenture certificate is the debenture holder of the company.

In this case, The company has no record of its debenture holders. 

Basically, the debenture certificate has some checks attached to it (according to the maturity period of the debenture and the dates at which interest was supposed to be paid at that date )with the date on them.

Certainly, On the specific date, the debenture holder can approach the bank and receive the interest through cheque.

ON THE BASIS OF INTEREST RATE

Intrest rate
On the basis of Interest rate

1>FIXED AND FLOATING RATE DEBENTURES

  • FIXED-RATE DEBENTURES

Certainly , these are those who have a fixed rate of interest.

  • FLOATING RATE DEBENTURES

Indeed, Floating rate are those who have an unfixed rate of the debenture.

ON THE BASIS OF NO COUPON RATE

1> ZERO COUPON AND SPECIFIC RATE DEBENTURES

  •  ZERO COUPON

Certainly, Zero-coupon debentures are those which have 0 coupon rate.

Also, these debenture holders don’t get any interest. But, they get the debenture at a lower price compared to its face value.

The difference between the value of the issue and the face value is called implicit interest. These are also called deep discount bonds.

  • SPECIFIC RATE

These are the regular ones that are issued by the companies.

2>SECURED PREMIUM NOTES

These are redeemed at a value greater than the face value of the debenture(redeemed over premium).

These are somewhat similar to zero-coupon bonds. In this case, the only difference lies between the discount and premium.

In a zero-coupon document, you get them at a discounted price and sold at par value whereas, a secured premium debenture is at par value and later redeemed at par.

CONCLUSION

DEBENTURES

DEBENTURES represent the acknowledgment of the debt by a company. They are creditor-ship securities that provide funds to the company on a loan basis rather than on a capital basis.

MERITS → 

1> CONTINUOUS INCOME

  It is a source of continuous income on the principal as there is a payment of a fixed rate of interest periodically.

2> SAFETY OF PRINCIPAL →

These could be preferred by those investors who consequently pay more weightage to the safety of the principal amount.

3> TRADING ON EQUITY

These offer the opportunity to the company to trade on equity and pay a higher rate of dividends to the shareholders.

5> FLEXIBILITY →

  These holders enjoy the flexibility to redeem debenture whenever the company has surplus funds.

6> TAX BENEFIT  →

Interest paid is charged from the profits of the company due to income tax purposes.

LIMITATIONS → 

1> NO CONTROL

The holders don’t have voting rights. Issuing these documents doesn’t weaken the share of old shareholders in the company. 

2> IMPACT ON CREDIBILITY → 

Issuing a lot of these may cause damage to the name of a company in the market.

3> FIXED BURDEN →

 Companies have to pay a fixed rate of interest every year ignoring profits.

TYPES OF DEBENTURES

1> ON THE BASIS OF CONVERTIBILITY

2> ON THE BASIS OF SECURITY

3> ON THE BASIS OF TRANSFER ABILITY/ REGISTRATION

4> ON THE BASIS OF INTEREST RATE

5> ON THE BASIS OF NO COUPON RATE

ALSO READ MY BLOG – DETAILED EXPLANATION ABOUT BONDS?

FREQUENTLY ASKED QUESTIONS(FAQ)

What are the major risks associated with debentures?

1>Liquidity risk.
2>Credit/default risk
3>Interest rate risk. The majority of debentures and unsecured notes have a fixed rate of interest and a fixed repayment of capital amount.

What is the difference between a debenture and a loan ?

Debenture vs Loan
In return, the company promises to return the principal amount at a specified date later and also promises to pay a fixed rate of interest to the lenders. Debentures are transferable while loans are not. Debentures do not need any collateral from the company whereas loans need collateral.

How do debentures work?

Put simply, a debenture is the document that grants lenders a charge over a borrower’s assets, giving them a means of collecting debt if the borrower defaults. Debentures are commonly used by traditional lenders, such as banks, when providing high-value funding to larger companies.

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