The term ‘debenture’ is derived from the Latin word ‘debere,’ which translates to ‘to borrow’ or ‘loan.’ In essence, debentures are formal debt instruments issued by companies as a means of raising funds. These instruments are executed under the company’s official seal, making them comparable to a loan certificate or a debt contract.
What are debentures?
Companies issue debentures to the general public as a legal agreement to repay the borrowed sum. The debenture specifies a fixed period for which the funds are borrowed and offers a pre-determined interest rate, which is typically paid either annually or semi-annually. Similar to equity shares, debentures are made available to the public at large, making them a widely used mechanism for large corporations to secure external financing.
Now, let’s explore some key characteristics that distinguish debentures:
1. Debt Instrument
Debentures serve as an instrument of debt, which means that the individuals or entities holding these debentures, referred to as debenture holders, are classified as creditors of the issuing company. Unlike equity shareholders, who are partial owners, debenture holders have no ownership rights.
2. Certificate of Debt
A debenture represents a formal certificate of indebtedness that clearly specifies the terms of the loan. This includes:
- The maturity date (also known as the redemption date) by which the borrowed amount must be repaid.
- The principal amount due for repayment.
This document, sealed and issued by the company, is commonly referred to as the Debenture Deed or Debenture Certificate.
3. Fixed Rate of Interest
Debentures typically come with a fixed interest rate, which is agreed upon at the time of issuance. The company is obligated to pay this interest to debenture holders at regular intervals, either on an annual or half-yearly basis, regardless of the company’s financial performance.
4. No Voting Rights
Debenture holders do not have any voting rights in the company. This is because debentures are debt instruments, not equity instruments. Since debenture holders are creditors and not shareholders, they do not participate in decision-making or management-related activities of the company.
5. Interest as a Priority Charge
The interest payments due to debenture holders are considered a priority charge against the company’s profits. This means that the company is legally bound to pay the interest, even if it incurs a financial loss. Unlike dividends paid to shareholders, which are discretionary and depend on profit availability, interest on debentures must be paid as per the agreed terms.
In summary, debentures provide a structured and reliable way for companies to borrow money while offering investors a relatively safe investment with fixed returns. However, debenture holders do not enjoy the privileges of ownership or decision-making within the company, as their role is solely that of a creditor entitled to timely repayment and interest.
Key Features of Debentures That Make Them Unique
- Debt Instrument:
Debentures are a form of debt issued by companies to raise capital. Debenture holders are considered creditors of the company, unlike shareholders who are owners. - Certificate of Debt:
A debenture is a legal document that specifies the loan amount, the date of repayment (redemption), and the interest rate. This document, called the Debenture Deed, is issued under the company’s seal. - Fixed Interest Rate:
Debentures carry a fixed interest rate, providing investors with regular income. The interest is paid annually or semi-annually, making it a predictable investment. - No Voting Rights:
Debenture holders do not have voting rights in the company’s decisions. They are creditors, not shareholders, and thus have no say in the company’s management or policies. - Priority in Interest Payments:
Interest payments to debenture holders are considered a priority charge on the company’s profits. The company must pay interest even if it incurs a loss, ensuring debenture holders receive their returns. - Secured or Unsecured:
Debentures can be either secured (backed by the company’s assets) or unsecured (not backed by assets), giving investors flexibility based on their risk appetite. - Maturity and Redemption:
Debentures have a fixed maturity period, after which the principal amount is repaid to the holders. This makes them suitable for investors seeking capital preservation over a defined time. - Tradability:
Debentures are often listed on stock exchanges, making them transferable and allowing investors to buy or sell them before maturity.
These features make debentures a unique investment tool for both companies looking for long-term financing and investors seeking stable returns with lower risk than equity investments.
Advantages of Debentures
Debentures offer several benefits to both companies and investors, making them a popular instrument for raising capital. Here’s a detailed look at the key advantages:
1. No Dilution of Equity
One of the most significant advantages of issuing debentures is that it allows companies to raise the required funds without diluting their ownership. Since debentures are a form of debt, issuing them does not affect the company’s equity structure. This means that existing shareholders retain their ownership stake and control over the company, making debentures an attractive option for businesses that wish to preserve their equity while still securing capital.
2. Tax Benefits on Interest Payments
The interest paid to debenture holders is treated as a business expense and is recorded as a charge against the company’s profits. This provides an additional advantage during tax planning, as interest payments on debentures are tax-deductible. By reducing the company’s taxable income, debentures help lower the overall tax liability, making them a cost-effective financing tool.
3. Facilitates Long-Term Funding
Debentures are designed to provide long-term financing for companies, which supports better financial planning and strategic growth initiatives. Unlike short-term loans or other forms of borrowing, debentures typically come with longer maturity periods. Moreover, they tend to be cheaper than other financing options, such as bank loans, because they often carry lower interest rates. This makes them a more economical option for companies seeking to fund long-term projects or expansions.
4. Lower Risk for Debenture Holders
From an investor’s perspective, debentures are considered a relatively low-risk investment. This is primarily because debentures are often secured by the company’s assets, providing a safeguard in case of default. Additionally, the company is obligated to pay interest on the debentures even if it incurs a financial loss, ensuring a steady income stream for investors. This feature makes debentures particularly attractive to risk-averse investors who prioritize capital preservation and fixed returns.
5. Effective During Inflation
In periods of inflation, debentures become a preferred instrument for raising funds. This is because they typically carry a fixed rate of interest, providing predictability in financing costs for the company. While other borrowing costs may rise due to inflation, the fixed interest rate on debentures remains unchanged, offering a stable and reliable funding mechanism. For companies, this predictability in interest payments during inflationary times makes debentures a practical and cost-effective choice for meeting their capital requirements.
Disadvantages of Debentures
While debentures offer several benefits, they also come with certain drawbacks that can impact a company’s financial health and operational flexibility. Below are some key disadvantages of debentures:
1. Fixed Interest Payments – A Financial Burden
One of the primary challenges of issuing debentures is the mandatory interest payments. Unlike dividends on equity, which are paid only when a company earns profits, interest on debentures must be paid regardless of the company’s financial performance. This creates a fixed financial obligation for the company, which can be particularly burdensome during periods of financial distress or losses, reducing overall profitability.
2. Dependence on Debt – Risk of Skewed Debt-Equity Ratio
While debentures can help a company leverage its equity to generate higher returns, excessive reliance on debt can lead to a skewed Debt-to-Equity Ratio. A high proportion of debt in the company’s capital structure increases its financial risk and may negatively impact its creditworthiness. This can make it difficult for the company to secure additional financing in the future and may also lead to increased scrutiny from investors and financial institutions.
3. Redemption – A Significant Cash Outflow
Debentures are typically issued for a specific term, after which the company must redeem them by repaying the principal amount to the holders. This redemption represents a substantial cash outflow that can disrupt the company’s liquidity and working capital management. If not planned carefully, this large financial commitment can strain the company’s resources and affect its ability to meet other operational or financial obligations.
4. Fixed Interest Rate – Expensive During Economic Downturns
Debentures usually carry a fixed rate of interest, which can become a disadvantage during economic downturns or periods of depression. When a company’s profits decline, the fixed interest payments on debentures remain constant, making them relatively more expensive. This inflexibility can further reduce the company’s profit margins and may lead to financial instability if the downturn is prolonged.
Types of Debentures
Companies issue debentures in various forms, depending on factors like security, tenure, and convertibility. Each type serves a specific purpose and caters to different investor needs. Let’s explore the key types of debentures in detail:
1. Secured Debentures
Secured debentures are backed by a charge or lien on specific assets of the company. In essence, the company pledges certain assets as collateral to secure the loan. If the company fails to repay the debenture holders, these assets can be sold to recover the outstanding amount.
- The charge created can be:
- Fixed Charge: Tied to a specific asset, such as land, building, or machinery.
- Floating Charge: Covers a broader range of assets, including inventory, receivables, and other current assets.
Secured debentures provide investors with a sense of security, as they have a claim on the company’s assets in case of default.
2. Unsecured Debentures
Unlike secured debentures, unsecured debentures are not backed by any specific asset of the company. There is no lien or charge created against any fixed or floating asset.
- These debentures rely solely on the company’s creditworthiness and promise to repay the borrowed amount.
- In India, unsecured debentures are less commonly issued due to the higher risk associated with them. Investors usually prefer secured debentures for the added safety they provide.
3. Redeemable Debentures
Redeemable debentures come with a predetermined maturity date on which the company is obligated to repay the principal amount to the debenture holders.
- The repayment can be made either:
- In a lump sum: A single payment at the end of the specified term.
- In installments: Spread over a period of time as agreed upon in the terms of issuance.
- These debentures may be redeemed:
- At par: Repaid at the original face value.
- At a premium: Repaid at a value higher than the face value.
- At a discount: Repaid at a value lower than the face value, though this is less common.
Redeemable debentures are popular because they offer a clear repayment timeline, making them attractive to investors looking for predictable returns.
4. Irredeemable Debentures
Irredeemable debentures, also known as perpetual debentures, do not have a fixed maturity date. They are typically not repaid until the company is either:
- Liquidated: When the company undergoes the process of winding up its operations.
- After a long, unspecified period: At the company’s discretion or as specified in the terms of issuance.
These debentures provide long-term financing for the company but may not be attractive to all investors due to the lack of a clear repayment schedule.
5. Fully Convertible Debentures (FCDs)
Fully convertible debentures offer debenture holders the option to convert their entire holding into equity shares of the issuing company after a specified period.
- Once converted, the debenture holder becomes a shareholder and gains ownership rights, including voting rights and a share in the company’s profits.
- FCDs are appealing to investors who anticipate the company’s equity value to appreciate over time, offering the potential for higher returns compared to fixed interest.
6. Partly Convertible Debentures (PCDs)
Partly convertible debentures provide holders with the flexibility to convert only a portion of their debentures into equity shares, while the remaining portion continues as a debt instrument.
- For instance, if a debenture holder owns 100 PCDs, they may convert 50 into equity shares while retaining the remaining 50 as debentures.
- After conversion, the holder becomes both a creditor and a shareholder, allowing them to benefit from fixed interest payments on the unconverted portion and potential dividends or capital gains from the converted portion.
7. Non-Convertible Debentures (NCDs)
Non-convertible debentures do not offer any option for conversion into equity shares. They remain as debt instruments throughout their tenure until maturity.
- Since they are purely debt-based, NCDs provide fixed interest income to the holders and are typically less volatile than equity-linked debentures.
- NCDs are the most commonly issued debentures, especially for investors seeking steady income and lower risk.
How Does a Debenture Work?
A debenture is a legal document that outlines specific details of a loan agreement between an investor and a company. It includes the following key information:
- The principal amount, which is the total sum of money the investor has lent to the company.
- The interest rate that the company agrees to pay on the principal.
- The payment schedule, specifying when and how interest payments will be made.
Typically, the company only pays the interest during the loan period, while the repayment of the principal is made in full upon the maturity of the debenture. The interest payments are calculated as a percentage of the loan’s face value. Once the debenture reaches maturity, the company is obligated to repay the entire principal amount to the investor.
According to Alka Sood, a financial consultant with BDC’s Advisory Services who advises businesses on financial management and strategic planning, debentures can be a practical funding option for:
- Entrepreneurs who prefer not to dilute their ownership by issuing equity.
- Fast-growing companies with limited assets but a need for substantial capital.
Since debentures represent a form of debt capital, they are recorded as liabilities on the issuing company’s balance sheet. Unlike secured loans, debentures are typically unsecured, meaning they are not backed by specific assets. As such, companies issuing debentures usually need to demonstrate strong creditworthiness, a solid reputation, and a history of positive cash flow to attract investors.
One distinctive feature of debentures is their marketability. Unlike conventional loans, debenture holders can sell their debentures to other investors, making them a tradable security. In fact, some corporate debentures are even listed and traded on stock exchanges, providing liquidity to investors.
From a risk perspective, debenture holders generally face less risk than shareholders. This is because companies are required to prioritize interest payments on debentures over the distribution of dividends to shareholders. Thus, debenture holders have a higher likelihood of receiving their returns, even in scenarios where the company faces financial challenges.
Understanding How a Debenture Works
A debenture is a formal financial instrument that outlines the terms of a loan agreement between an investor and a company. This legal certificate contains important details such as:
- The principal amount, which indicates the total sum of money the investor has provided to the company.
- The interest rate that the company commits to pay on the borrowed amount.
- The payment schedule, which specifies when and how the interest payments will be made over the loan term.
During the life of the debenture, the company typically makes periodic interest payments to the investor based on a fixed percentage of the principal or the face value of the loan. These interest payments serve as the primary return for the investor during the loan period. However, the full principal amount is usually repaid in a lump sum when the debenture reaches maturity—that is, at the end of the specified term.
Debentures as Debt Capital
Debentures represent a form of debt capital for the issuing company, meaning they are recorded as liabilities on the company’s balance sheet. Unlike traditional loans, which are often secured by collateral, debentures are typically unsecured. This means they are not backed by specific assets, and the company relies on its creditworthiness and financial stability to attract investors.
Marketability of Debentures
One key feature that distinguishes debentures from other forms of debt is their marketability. Unlike a conventional loan, a debenture holder—the investor lending the money—has the flexibility to sell the debenture to another party before it matures. This characteristic makes debentures a tradable financial instrument. In fact, some corporate debentures are even listed and traded on stock exchanges, providing liquidity and an opportunity for investors to exit their investment before maturity if needed.
Risk Comparison: Debenture Holders vs. Shareholders
From a risk perspective, debenture holders typically face lower risk compared to shareholders. This is because the company is obligated to prioritize interest payments to debenture holders over the distribution of dividends to its shareholders. Even if the company experiences financial difficulties or reduced profits, it must still fulfill its interest payment obligations to debenture holders before considering any dividend payouts. This preferential treatment provides debenture holders with a more stable and predictable return on their investment, making debentures an attractive option for risk-averse investors seeking fixed-income securities.
Key Features of a Debenture in Detail
A debenture is a structured debt instrument issued by a company to raise capital from investors. It contains detailed terms and conditions of the loan, providing clarity to both the issuing company and the debenture holder. Below are the essential features that define a debenture:
1. Loan Amount (Principal)
The loan amount or principal is the initial sum of money that the investor lends to the issuing company. It is specified on the debenture certificate and represents the face value of the debenture. This principal amount is what the company is obligated to repay upon maturity.
2. Interest Rate (Coupon Rate)
The interest rate, also referred to as the coupon rate, is the fixed or variable rate at which the company agrees to pay interest to the debenture holder. This interest is typically expressed as a percentage of the principal amount and is paid periodically, such as annually, semi-annually, or quarterly. The coupon rate remains a critical factor for investors seeking stable income from their investments.
3. Repayment Schedule (Redemption Schedule)
The repayment schedule outlines when and how the interest payments and principal repayment will occur. This schedule may involve periodic interest payments throughout the loan term, with the principal amount repaid either:
- In a lump sum at the end of the debenture’s term (bullet repayment), or
- In installments over a specified period of time.
This structured timeline ensures that investors have a clear understanding of when they can expect payments.
4. Maturity Date
The maturity date refers to the date when the debenture reaches the end of its term and the issuing company is required to repay the full principal amount to the investor. Depending on the type of debenture, the maturity period can range from a few years to several decades. Some debentures, known as perpetual debentures, may not have a fixed maturity date and are only repayable upon liquidation.
5. Convertibility
Some debentures come with the option of convertibility, allowing debenture holders to convert their debt into equity shares of the company after a specified period. Based on this feature, debentures are categorized into:
- Fully Convertible Debentures (FCDs): The entire principal amount can be converted into equity shares.
- Partly Convertible Debentures (PCDs): A portion of the principal is converted into equity, while the remaining amount continues as debt.
- Non-Convertible Debentures (NCDs): These debentures do not offer any conversion option and remain debt instruments throughout their term.
Convertibility provides debenture holders with the opportunity to become shareholders, potentially benefiting from the company’s growth.
6. Credit Rating
The credit rating of a debenture reflects the financial stability and creditworthiness of the issuing company. It is assigned by independent credit rating agencies and helps investors assess the risk associated with the debenture. A higher credit rating indicates lower risk and greater likelihood of timely interest and principal payments, while a lower rating signifies higher risk. Common credit rating agencies include:
- CRISIL
- ICRA
- CARE Ratings
- Fitch Ratings
The credit rating is a crucial factor influencing investors’ decisions, as it provides insight into the company’s ability to meet its debt obligations.
7. Seniority of Repayment
The seniority of repayment determines the priority with which debenture holders will be repaid in the event of the company’s bankruptcy or liquidation. This seniority affects the risk level associated with the debenture.
- Senior Debentures: These have a higher claim on the company’s assets and are repaid before other debts or obligations.
- Subordinated Debentures: These are repaid after senior debts have been settled and carry higher risk, but often offer higher interest rates as compensation.
The seniority level is essential for investors, as it directly impacts the likelihood of recovering their investment in case of financial distress.
Structure of Debentures
Debentures are a form of long-term debt financing issued by companies to raise capital. Typically, debentures have a maturity period ranging from five to ten years, although this can vary depending on the specific terms of the issue. Being unsecured debt instruments, debentures generally come with a higher interest rate compared to secured loans or bonds. This higher interest rate compensates for the increased risk faced by investors, as the company’s assets are not pledged to guarantee repayment.
In case of a bankruptcy or liquidation, debentures are treated as a type of unsecured debt. However, they hold a higher priority than equity shareholders (both common and preferred shares) in terms of repayment. Depending on the terms specified in the debenture issue, these debentures may even be ranked above other unsecured loans in the event of liquidation, giving them a degree of seniority among other creditors.
Redemption of Debentures
The process of redeeming or repaying debentures is outlined in the debenture certificate and is based on the specific conditions set by the issuing company. Debentures can be redeemed in several ways, depending on the agreement between the company and the debenture holders. Common methods of redemption include:
- Lump-Sum Payment: At the time of maturity, the company may repay the entire amount of the principal and any accrued interest in a single lump sum. This occurs at the maturity date, when the full outstanding debt becomes due.
- Installment Payments: Instead of a lump-sum repayment, debentures may be repaid over time through scheduled payments. These installments could be annual, semi-annual, or on another mutually agreed schedule. The interest payments are typically made periodically during the term of the debenture.
- Conversion into Equity: In the case of convertible debentures, the holder has the option to convert their debentures into the company’s equity shares at a predetermined ratio, either partially or in full. Alternatively, the company might issue a new debenture to replace the existing one. The terms of conversion are set in advance, often providing debenture holders with an opportunity to become shareholders in the company, depending on the structure of the debenture.
Debenture vs. Bonds: Key Differences
Debentures and bonds are both methods for businesses to raise capital through borrowing, but there are important distinctions between them:
| Feature | Debenture | Bond |
| Secured | No, typically unsecured | Can be secured or unsecured |
| Maturity Date | Generally long-term | Can be either long-term or short-term |
| Convertibility | Sometimes convertible into equity | Not convertible |
| Seniority | Paid after bonds in case of liquidation | Paid before debentures in case of liquidation |
Debenture vs. Shares
A debenture represents a long-term debt obligation for a company and is recorded under the liabilities section of its balance sheet. In contrast, shares represent ownership in the company, and their value is listed in the shareholders’ equity section of the balance sheet. Essentially, debentures are loans that the company must repay, while shares denote a claim to ownership and profit.
Debenture vs. Loan
While a debenture is a type of business loan, not every business loan is a debenture. For example, a secured loan, which is backed by collateral, is not considered a debenture. A debenture, however, is an unsecured loan issued by the business as a promise to repay the borrowed sum. Traditional loans, on the other hand, are typically issued by the lender, and may or may not be secured by collateral.
It’s also important to note that not all unsecured loans are debentures. For example, a business might receive a working capital loan from a financial institution that isn’t secured by collateral, and such loans aren’t classified as debentures. A debenture is distinct in that it is issued by the company borrowing the funds, not by the lender.
Who Can Issue a Debenture and How?
To issue a debenture, a company creates a debenture certificate, which serves as a promise to repay the borrowed funds. This certificate outlines the amount borrowed, the interest rate, and the terms of repayment.
Since debentures are unsecured and not backed by physical collateral, the company issuing them must generally be creditworthy with a strong reputation and a positive cash flow history. This ensures that investors are confident in the company’s ability to repay the debt.
US vs UK Debentures
The concept of a debenture differs somewhat between the US and the UK, particularly in terms of security and structure.
In the US, a debenture typically refers to a medium- to long-term loan that a company receives from an investor. Unlike in the UK, US debentures are often unsecured, meaning they are not backed by specific assets of the company. Instead, the loan is granted based on the company’s reputation and its ability to generate cash flow, with investors relying on the business’s creditworthiness rather than physical collateral.
These debentures must be repaid at a fixed interest rate, with the raised funds used as capital for the business operations.
In the US, there are two main types of debentures:
- Convertible Debentures: These can be converted into the company’s equity shares at a specific point in time, which usually leads to lower interest rates. This option appeals to investors seeking the potential for equity ownership.
- Non-Convertible Debentures: These cannot be converted into shares and typically offer higher interest rates to compensate for the lack of conversion benefits.
If the company fails to repay the debenture, investors have the right to claim the company’s tangible assets, even if those assets were not initially pledged as collateral. This gives debenture holders more protection compared to other types of unsecured debt, where claims are usually limited.
Pros and Cons of Debentures
Pros of Debentures
Pros for the Lender (Investor)
- Higher Interest Rates: Debentures typically offer higher interest rates compared to other investments like bonds, making them attractive to investors.
- Convertible Option: Convertible debentures can be exchanged for equity shares in the company, offering potential for greater returns if the company performs well.
- Transferability: Debentures are transferable, meaning investors can sell them to other financiers, giving them liquidity and flexibility.
Pros for the Borrower (Company)
- Unrestricted Funding: Companies can raise funds without restrictions on the amount they can borrow, unlike regular loans which may have limits.
- No Collateral: Debentures are often unsecured, so businesses do not need to pledge specific assets to secure the loan.
Cons of Debentures
Cons for the Lender (Investor)
- Interest Rate Risk: Debentures carry interest rate risk because the interest is fixed. If interest rates rise, the lender may earn less compared to other investments that benefit from higher rates.
- Inflation Risk: The fixed interest payments may not keep up with inflation, potentially reducing the real value of the returns for the lender.
Cons for the Borrower (Company)
- Compulsory Interest Payments: Borrowers are required to make compulsory interest payments, which reduces their financial flexibility.
- Potential Losses: If the borrower is unable to repay the debenture, they could face significant consequences, as stipulated in the indenture agreement, including loss of assets or other financial penalties. This could result in the company losing more than it initially borrowed.
What Should a Debenture Document Include?
A debenture document should include the following key details:
- Total Amount Borrowed
- Interest Rate (and whether it is fixed or variable)
- Total Repayment Amount
- Repayment Schedule (timeframe for repayments)
- Other Charges or Conditions that may apply
Types of Debenture Charges
Fixed Charge
- A fixed charge applies to specific assets, often property, meaning the borrower cannot sell or transfer the asset without the lender’s permission. Any proceeds from a sale of such an asset go directly to the lender. Alternatively, funds from a sale can be used to purchase a new asset, which the lender can place a fixed charge on.
Floating Charge
- A floating charge is more flexible, applying to a range of assets like raw materials, business fixtures, or even intellectual property. The borrower can continue to use or sell these assets in the normal course of business. However, if certain events (called crystallisation events) occur, the floating charge will “crystallize” into a fixed charge, giving the lender control over the assets involved.
Debentures are a popular type of unsecured bond issued by both corporations and governments. Unlike secured bonds, which are supported by collateral, unsecured bonds carry a higher level of risk since they are not backed by any assets. Instead, their repayment depends entirely on the issuer’s creditworthiness. In this sense, U.S. Treasury bonds can technically be considered debentures. The entire stock broki
