What is a Debenture?

Debenture Definition

A debenture is a type of debt instrument companies use to borrow money from investors. Unlike traditional loans, debenture use a business' creditworthiness and reputation instead of collateral. 

Why is Debenture Important?

A debenture enables businesses to raise money by borrowing from the public instead of taking out a bank loan or issuing shares. The company promises to pay the principal amount with interest rate over a certain period.

How Does a Debenture Work?

Businesses use debenture when they need more funds to grow, invest in new projects, or manage debts. It is an unsecured debt due to its reliance on the company's reputation and financial health rather than physical assets for security.

Investors buy these debentures because they offer a fixed interest rate, which can be more attractive than other investment options, especially if the company has a strong credit rating. The interest paid on debentures is a borrowing cost for the company but is an income for the investors. Additionally, certain debentures provide options for equity shares conversion, offering the potential for capital gains if the company performs well.

A business benefits from debentures as they provide a flexible and often cheaper source of capital compared to equity financing, where issuing new shares dilutes ownership and may affect the stock price. On the other hand, investors get a relatively safe investment that generates regular income, assuming the company remains financially stable.

Uses of Debenture in Business Finance

There are several reasons why businesses use debentures, which include:

• Expansion and Growth: Companies often need large amounts of money to expand their operations, enter new markets, or develop new products. Debentures provide a significant source of funds to support these activities.
• Refinance Existing Debt: Sometimes, companies issue debentures to refinance their existing debts, especially if the debentures offer more favorable payment terms, such as a lower interest rate or longer repayment period.
• Maintain Control: Unlike equity financing, where issuing new shares dilutes the ownership and control of existing shareholders, debentures do not affect the company's ownership structure. It allows the original owners to retain control with access to capital.
• Capitalize on Tax Advantages: The interest paid on debentures is tax-deductible for the company, which can provide a tax advantage over other forms of financing.

Types of Debentures

Debentures come in various types, each offering different risks and rewards, making them suitable for investors based on their investment goals, risk tolerance, and expectations of the company's future performance. 

Secured and Unsecured Debentures

A secured debenture pledges a company's specific assets as collateral. For example, if the company fails to repay the debt, it sells these assets to meet the obligations. Unsecured debentures do not have any collateral backing them and rely solely on the creditworthiness and reputation of the issuing company.

Convertible and Non-Convertible Debentures

Convertible debentures can become equity shares of the issuing company after a certain period or under certain conditions. This feature is attractive to investors looking for the potential to convert their debt investment into ownership stakes. Non-convertible debentures cannot be equity shares and are repaid at the end of their term.

Registered and Bearer Debentures

The company's register of debenture holders records the registered debentures. The interest and principal are paid directly to the registered holders. The register does not record bearer debentures. They are payable to the instrument holder, similar to currency notes, making them easier to transfer but riskier in terms of security.

Redeemable and Perpetual Debentures

A redeemable debenture comes with a specific maturity date for the principal amount repayment. A perpetual debenture, also known as an irredeemable debenture, does not have a maturity date. The principal on these debentures is paid back at the company's discretion or upon liquidation.

Fixed and Floating Charge Debentures

A fixed-rate debenture comes with a specific interest rate throughout the term. Floating charge debenture interest rate adjusts periodically based on a benchmark rate. It can be appealing to investors looking for protection against interest rate fluctuations.

Key Features of Debentures 

Debentures, as financial instruments, come with several distinctive features, appealing to the issuing companies and investors. Here are the key features of debentures:

• Fixed Interest Rate: Debentures offer a fixed rate of interest to investors, which means the company agrees to pay a set amount of interest annually until the debenture matures. Fixed charge provides a predictable income stream for investors.
• Repayment Schedule: The company repays the principal amount on a predetermined date. This maturity date is set when the debenture is issued, giving investors a clear understanding of when they will get their initial investment back.
• Security: Secured debentures are backed by specific assets of the company. Investors can claim these assets if the company fails to pay the debenture. Unsecured debentures, while not backed by specific assets, are supported by the overall creditworthiness of the issuing company.
• Convertibility: Certain debentures offer the option to convert into equity shares of the issuing company after a specific period. It is attractive to investors who believe in the company's growth potential and wish to share the profits more directly.
• Credit Rating: Debentures often have a credit rating that indicates the risk associated with investing in them. Higher-rated debentures are considered safer but might offer lower interest rates, while lower-rated debentures offer higher interest rates to compensate for the increased risk.
• Tax Benefits: For the issuing company, the interest expense on debentures is tax-deductible, making it a tax-efficient method of raising capital. For investors, the interest income from debentures is taxable, but the tax treatment may vary depending on the investor's country of residence and specific tax laws.
• Tradability: Debentures can be traded on the stock market, offering liquidity to investors. This means investors can sell their debentures before maturity if they need access to their investment or wish to realize a capital gain.
• Legal Documentation: The terms and conditions of a debenture issue are detailed in a legal document known as the "debenture indenture." This document specifies the rights and obligations of both the issuing company and the debenture holders, including the interest rate, repayment schedule, security (if any), and convertibility options.

FAQs

What is the Difference between debenture and bond?

The main difference between a debenture and a bond lies in their security and where they are commonly issued. Debentures are typically unsecured debt instruments, meaning they are not backed by any collateral but rather by the issuer's creditworthiness. They are more common in countries like the UK and India. Bonds, on the other hand, are usually secured, meaning they are backed by specific assets of the issuer, and are a popular way to raise capital in the United States. Both debentures and bonds are ways for entities to borrow money from investors and pay back with interest, but the level of security and the typical market of issuance distinguish them.

Who is a Debenture holder?

A debenture holder is an individual or entity that has invested in debentures issued by a company. By purchasing a debenture, the holder is essentially lending money to the company and, in return, receives a certificate of debenture. This certificate is a legal document that entitles the holder to receive interest payments at fixed intervals and the repayment of the principal amount on the debenture's maturity date. Debenture holders are creditors to the company, not shareholders, which means they have a right to receive interest payments and the return on their investment as specified in the debenture agreement, but they do not have ownership rights or a say in the company's management.

What is the Difference between a Debenture and a Share?

Debentures and shares represent two different ways of investing in a company. When you buy a debenture, you are lending money to the company. The company agrees to pay you back with interest by a certain date. Shares, on the other hand, represent ownership in the company. Buying shares makes you a shareholder, giving you a stake in the company's profits through dividends and the potential for capital gains if the share price increases. While debenture holders are creditors who receive interest regardless of the company's performance, shareholders' returns depend on the company's profitability and share price movements.

What is a Compulsory Convertible Debenture?

Compulsory Convertible Debentures (CCDs) are a type of debenture that investors must convert into equity shares of the issuing company after a predetermined period. This means when you invest in CCDs, you are lending money to the company with the understanding that instead of getting your investment back in cash with interest, you will receive company shares. The conversion rate, which determines how many shares you get for each debenture, is fixed during issuance. CCDs are a tool for companies to raise capital with the future promise of converting debt into ownership stakes, providing a way for investors to become shareholders and potentially benefit from the company's growth.

How to Calculate the Cost of Debentures?

To calculate the cost of debentures, you need to consider the interest payments, the issuance and redemption prices, and any taxes or fees involved. First, calculate the annual interest payment by multiplying the debenture's face value by its interest rate. Then, adjust for any tax benefits, such as the tax deductibility of interest payments. If there are issuance costs or a difference between the debenture's issuance and redemption prices, factor these into your calculation. The cost of debentures is often expressed as an annual percentage of the net proceeds received by the company, giving a clear picture of the true cost of borrowing through debentures.