What Is a Debenture, and How Does It Work?

To break it down even further, you can think of a debenture as an agreement between a borrower and a lender. The agreement gets registered at Companies House and it gets lodged against your business assets. Debenture holders are creditors because they have lent money to the company through the sale of Debentures. Creditor means an entity that has a claim to receive money from another.

• All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
• These debt securities are a common form of long-term financing taken out by corporations.
• Unlike a typical loan, a debenture owner (the person or entity lending the money) can sell the debenture to another party.
• Corporate debentures are most commonly used for long-term loans, which have a fixed date for repayment as well as a fixed interest rate.
• But in our country, most of the institutional investors are public sector institutions.

Normally the maturity period is longer than the other sources of finance. Further, the company has to pay interest regardless of whether it makes profits or not. There are various types of debentures that a company can issue, based on security, tenure, convertibility etc. The word ‘debenture’ itself is a derivation of the Latin word ‘debere’ which means to borrow or loan. Debentures are written instruments of debt that companies issue under their common seal.

The call price may be more than the part/face value by usually 5 percent, the difference being the call premium. The put option is a right to the debenture holder to seek redemption at a specified time at predetermined prices. The definition of debentures under Companies Act, 2013 says companies cannot issue debentures carrying voting rights. Hence, companies are free to issue many other types of debentures. Debentures have no collateral backing, hence debentures must rely on the issuer’s creditworthiness and reputation for support.

Debentures

In a sense, all debentures are bonds, but not all bonds are debentures. Whenever a bond is unsecured, it can be referred to as a debenture. Options trading entails significant risk and is not appropriate for all customers.

A company will issue these to raise capital for its growth and operations, and investors can enjoy regular interest payments that are relatively safer investments than a company’s equity shares of stock. Convertible debentures are bonds that can convert into equity shares of the issuing corporation after a specific period. Convertible debentures are hybrid financial products with the benefits of both debt and equity.

Some debt, however, is considered “unsecured.” In this case, lenders are willing to purchase bonds simply because they trust the borrower. Large companies with lots of money and good cash flow—and the good credit ratings that come with that—can usually get away with offering unsecured debt. A debenture is a type of long-term business debt not secured by any collateral. It is a funding option for companies with solid finances that want to avoid issuing shares and diluting their equity. Debentures can also be useful for companies that don’t want to tie up assets or who lack collateral for a traditional loan.

• It boils down to the underlying issuer being more likely to default on the debt.
• Debentures don’t have any collateral backing them up, so the credit rating of the company or government issuing them is especially important.
• If interest rates rise after you invest in a debenture, you may miss out on higher yields if you’re locked in at a lower rate.
• The conversion ratio and the period during which conversion can be affected are specified at the time of the issue of the debenture itself.
• The charge is floating as some of the assets may be changing on a daily basis, such as stock for example.
• A fixed charge is normally taken out against a tangible asset such as property.

These are considered risk free due to the fact that the government can pay back the amount owed, getting the resources from taxes. Corporate debentures are most commonly used for long-term loans, which have a fixed date for repayment as well as a fixed interest rate. As stated earlier, debentures are only as secure as the underlying issuer’s financial strength. If the company struggles financially due to internal or macroeconomic factors, investors are at risk of default on the debenture.

In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term „debenture“ originally referred to a document that either creates a debt or acknowledges it, but in some countries the term is now used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the company’s liability to pay a specified amount with interest. Bonds can be useful for adding a conservative component to an investment portfolio to balance out stocks or other high-risk securities. Debentures are a specific type of bond that government entities or corporations can use to raise capital. The biggest difference between the two has to do with how they’re collateralized.

Advantages and Disadvantages of Debentures

At first blush, it might seem like investing in debentures is a worse deal. After all, you don’t get to enjoy any of the perks of the company’s growth potential. But these bonds generally come with a lot less risk than buying stock in a company. While your interest payments don’t change based on the company’s profits, they generally don’t change based on the company’s losses as long as you don’t sell your debentures. If the company’s stock performs poorly, shareholders can lose money while debenture holders will likely continue to receive their interest payments so long as the company’s poor performance does not get worse. And if the company goes under, debentures usually have precendence over shareholders when it comes to being made whole.

Debentures vs. Traditional Bonds

In this case, it would be an individual who has purchased a Debenture from the company. Debentures may also be issued to banks and financial institutions as an additional or subsidiary security, in addition to certain principal security. The amount of the debentures is to be repaid within the period what are prepaid expenses specified in the terms of their issue. Bonds and debentures provide companies and governments with a way to finance beyond their normal cash flows. To complicate matters, this is the American definition of a debenture. In British usage, a debenture is a bond that is secured by company assets.

According to the Companies Act, 2013, a debenture generally may include stocks, bond other instruments. When we start issuing a debenture as a first step, a trust indenture should be drafted. Usually the first trust is an agreement between the issuing corporation and the trustee which manages the interest of investors. Or, a larger corporation might be looking to raise capital for their expansion project. When these scenarios happen, a debenture acts as a type of long-term financing.

Understanding Debentures

Debentures are financial instruments through which companies can raise debt. They are basically documents that evidence the  existence of a debt in a company’s name. Companies issue debentures extensively because debt capital is cheaper to raise. Let’s take a look at the various types of debentures companies can issue.

Put simply, the borrower issues a debenture via an agreement called an indenture. Depending on the country of issue, this agreement outlines details such as the amount of the loan, its convertibility, interest rate and maturity date. Then, the investor lends the funds to the borrower and expects repayments at the agreed interest rate. Credit risk is also something to consider, though again, companies or governments that issue debentures typically have stronger credit ratings.

Types of Debentures on the basis of their Priority

On the due date, the company has two general choices of repayment of principal. The installment plan is known as a debenture redemption reserve, and the company will pay a set amount each year to the investor until maturity. The terms of the debenture will be listed in the underlying documentation. It’s important to note that not all unsecured loans are debentures. For example, some financial institutions offer businesses working capital loans that are not secured by any collateral.

A convertible debenture can be exchanged for the company’s shares during a certain period and often offer lower interest rates. A non-convertible debenture cannot be converted into shares and often carries a higher interest rate. Again, all debentures are bonds, but not all bonds are debentures.

These are special features added to promote a product or attract investors, some of which are given to A-listers – those who have a significant financial position in society. Companies may offer a profit-sharing plan to employees as a type of debenture. Debentures are generally lower-risk investments than stocks but they aren’t entirely risk-free. There are some specific factors to consider when evaluating whether they’re a good fit.