To understand what are debentures, you first need to understand what is debt. After all, debenture is a debt instrument.
Imagine you want to buy your dream home. After surfing for days on the web, you find the ideal apartment for you and your family. It comes with 30+ amenities and costs you around Rs 1 crore. For now, you have Rs 30 lakhs in hand for the down payment.
What will you do for the remaining 70 lakhs?
You will take a loan from the bank, correct?
Likewise, companies also need capital for:
- New projects
- Purchasing new machinery and equipment
- Research & Development
- Financing working capital
- Repaying their debt etc.
To fund their projects they prefer borrowing money from investors like you and me.
They can either raise funds through equity or issue a debt security like debentures. Companies usually avoid issuing equity shares as it dilutes their share capital. Also, the process of issuing shares is time consuming and expensive.
So, to raise additional capital companies prefer issuing debentures.
In this article we will cover
- What are debentures?
- Why does a company issue debentures?
- Types of debentures
- Advantages of debentures
- Disadvantages of debentures
- How can you buy debentures
- Difference between debentures, shares and bonds
Let us first understand the basics and explore what is a capital market?
What are Debentures?
When you buy a company’s debentures, you lend capital to the company. In return, the company offers you a promissory note. This note is known as a debenture. It promises to repay you the principal amount with a fixed interest rate after a particular tenure.
Debentures are like bonds. If the company decides to issue bonds, they have to mandatorily back it up with a collateral. Whereas, in case of debentures keeping collateral is optional.
Why does a company issue debentures?
Let’s say the company wants to set up a new plant. To finance the project what are the possible options available?
- The company can approach for a bank loan. The scenario would be pretty much like the apartment case we had discussed.
- The company can gather money from small investors. So, instead of paying interest to the bank. The company will pay interest to its investors.
But why would a company prefer raising funds from the general public than from a bank?
The reason behind this is when banks lend money to the company they impose certain restrictions on how the money can be used. For example, the raised capital can be only used for capital expenditure. Also, companies cannot take additional loan till the current loan is repaid. Hence, raising capital from the general public is much more convenient for the company.
Let us move ahead and understand the various types of debentures.
Types of debentures
On The Basis of Security
1. Secured debentures
This is similar to buying an apartment on loan. When you take a home loan, the asset is pledged with the bank as collateral. If you are unable to repay the loan then the bank will seize and sell your asset to recover the loan.
Similarly, secured debentures are backed by collateral. If the company goes bankrupt your money would be recovered by selling the asset.
This is further divided into two.
- Fixed charge asset: These debentures are issued against a particular asset. Hence, they cannot be sold without the consent of the debenture holders.
- Floating charge asset: These debentures are issued against generic assets of the organisation.
2. Unsecured debentures
This is similar to taking a personal loan from a bank. There is no collateral in this case. The bank lends you based on your credit score and charges high interest rates.
Likewise, unsecured debentures are not backed by collateral. Investors invest in them on the basis of the credibility of the company. Hence, companies pay high interest to its unsecured debenture holders.
On The Basis of Tenure
1. Redeemable Debentures
These debentures are repayable after a certain period as per the terms of the issue. The date of redemption is specified on the promissory note These debentures can be redeemed either at par or premium.
- Redemption at par: When the redemption price of the debenture is equal to its face value, it is said to be redeemed at par.
- Redemption at premium: When the redemption price of the debenture is more than its face value, it is said to be redeemed at a premium. For example, a Rs 100 debenture is redeemed for Rs 102. Then Rs 2 is the premium.
2. Irredeemable debentures
These are also called perpetual debentures. They do not carry a redemption date and are redeemed only if the company liquidates. So if the company becomes insolvent, these debenture holders are the first to receive their funds.
On The Basis of Convertibility
1. Convertible debenture
These debentures are converted into equity shares after a certain period of time after the issue. They can be fully convertible or partly convertible.
Fully convertible debentures are entirely converted into equity shares. However, with partly convertible debentures only a limited part is converted into equity.
2. Non convertible debenture
These debentures cannot be converted into equity shares in the future. They have a fixed maturity date. The interest can be paid along with the principal amount either monthly, quarterly, or annually depending on the specified tenure.
On The Basis of Registration
1. Registered debentures
The interest on these debentures is paid to those investors who are registered debenture holders. So in case of transfer of ownership, the investor needs to inform the organisation. Or else the interest will be credited to the previous debenture holder.
2. Bearer debenture
These debentures are not registered with the company. Hence they are easily transferable. The interest on the debenture is paid to the person who holds the debenture currently.
Advantages of Debentures
Advantages of debentures to investors
- All the debenture holders of the company earn a fixed rate of return.
- Compared to fixed deposit debentures pay a higher rate of interest.
- Debentures are liquid and could be traded on the National stock exchange (NSE) and the Bombay stock exchange (BSE).
- The interest of debenture holders is protected by numerous provisions of the trust deed and guidelines issued by the Securities and Exchange Board of India (SEBI).
Advantages of debentures to the issuing company
- Issuing debentures is one of the most economic ways to raise funds.
- Raising funds through debenture does not dilute the control of the management. This is because debenture holders do not get any voting rights.
- The company can easily redeem the debentures when they have surplus funds.
Disadvantages of Debentures
Disadvantages of debentures to investors
- Debentures do not carry any voting rights. Hence its holders do not have any control over the management decisions.
- These debenture holders are creditors of the company. Hence, they cannot claim excess profits of the company beyond the fixed interest rate and the principal amount.
Disadvantages of debentures to the issuing company
- The interest rates and repayment of principal amount are legal obligations of the company. These have to be paid even if there are no profits. Hence, it is a financial burden on the company.
- Default payment adversely affects the creditworthiness of the company.
- The assets of the company used as collateral are mortgaged to debenture holders. So, the company cannot raise further loans against those assets. It restricts the company from raising additional capital.
How Can You Buy Debentures?
Listed companies issue debentures on BSE and NSE. Here, these debentures are publicly traded. So, you can either buy it when the company announces the issue. Or you can buy it in the secondary markets when it is trading.
When you buy a debenture, credit rating is the most important things to consider.
Think of it this way. When you approach the bank for a loan they consider a lot of things before approving your application. One of them is your credit score. It helps the bank understand if you have the ability to repay the loan. Higher the score, the easier it is to get the loan.
Similarly, each debenture has a credit score. It is rated by a credit rating agencies like Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency of India (ICRA) and Credit Analysis & Research Limited (CARE). The score ranges from AAA to D.
Here is ICRAs long term rating scale.
|AAA||Highest degree of safety and lowest credit risk|
|AA||A high degree of safety and low credit risk|
|A||An adequate degree of safety and low credit risk|
|BBB||A moderate degree of safety and moderate credit risk|
|BB||Moderate risk of default|
|B||High risk of default|
|C||Very high risk of default|
|D||The security has already in default or is expected to be in default soon|
Please note: Credit rating agencies use modifiers + (plus) or – (minus) to indicate their relative position within the rating categories. Thus, the rating of AA+ is one notch higher than AA, while AA- is one notch lower than AA.
The value of NCD depends on the credibility of the company. Hence, you must check the credit rating of the debenture before investing. It is advisable to buy debentures that are rated AAA+ or AA+. The higher the rating, more secured the debenture will be.
You can find the list of all tradable debentures here.
Also Read: Credit rating and the Agencies
Tax Implications on Debentures
- If you hold debentures till maturity, the returns are clubbed with your income and are taxed as per your income tax slab.
- If you sell your debenture on the stock exchange before a year, then you will have to pay short term capital gain as per your income tax slab.
- If you sell your debenture after a year but before maturity, you will have to pay a long term capital gain at 20% with indexation.
Difference Between Debentures, Shares and Bonds
|Brief||A debenture is a form of debt. It is raised from the general public. In return, the company pays a fixed interest rate. These investments can be secured or unsecured.||The capital raised by distributing small parts of company’s ownership to the general public is a share. The investors are called shareholders and are part owners of the company.||Bonds are similar to debentures. It is a way to raise capital for the long term. It is backed by collateral and are secured.|
|Liquidation||If you are an unsecured debenture holder, then you will be paid after bond holders.||The company is not obliged to repay its equity shareholders. They are paid after all other creditors.||Bond holders are paid before debenture holders.|
|Return||In case of unsecured debentures, interest rate paid is high.||Shareholders may or may not get dividends every year. It depends on the management’s decision.||Bond are regarded as a safe haven for investors. This is because it is backed up by collateral. Hence, they are considered safer and provides low returns.|
|Controlling rights||Debenture holders cannot control the management as they do not get voting rights.||As owners of the company, shareholders have voting rights. Hence, they can control management decision to some extent.||Similar to debentures, bond holders do not have voting rights.|
|Conversion option||Only convertible debentures can be converted into equity shares after a specific period of time.||Shares are not convertible into any other asset.||Even bonds cannot be converted into any other asset.|
Even though the interest rate of debentures is lucrative, they come with a certain amount of risk too. This was seen in 2016 in the case of Dewan Housing Finance Ltd. (DHFL). CARE had given AAA rating to DHFL’s debentures. Later, in 2019 the company started defaulting on its payments. Suddenly, CARE downgraded them to default rating (D). All of this happened in the span of three months.
Due to this, many DHFL debentures holders had to face heavy losses. So, you not only need to analyse the credit rating but also look for the credibility of the issuer yourself. You can do this by simply reading the balance sheet of the company and analyse the cash flow statement. This additional research will ensure you both good returns and peace of mind.
To know how to read a balance sheet – Click here.
To know how to read a cash flow statement – Click here.
Moreover, investing in debentures online has made things a lot easier. They are not only lucrative but also highly liquid.