Understanding what is Debenture: Investors are always on the lookout for financial instruments to enhance their portfolios. One such instrument is Debentures. In this article, we will answer the questions like – what is debenture, what kind of investments they are, and how they work. Let’s get started.
What is Debenture?
Debentures are debt instruments used by corporations to secure long-term debt. These instruments pay an interest rate (coupon rate) to the investors. At the same time, they exist for a limited period post which the capital is redeemed or repaid to the investors (debenture holders).
Corporations prefer to issue debentures as their features can be adjusted to the requirements of the company. For eg., they generally have a lower interest rate and longer repayment periods in comparison to traditional loans.
The interest paid to debenture holders is paid out of the profits made by the company. Debenture holders are given priority over the shareholders for the interest payment. The interest due to debenture holders is paid to the debenture holders first from the profits and the remaining may be utilized for dividends etc. Also in the case of liquidation of a company, debentures have priority over preferential and equity shares.
These securities do not have any collateral, hence are unsecured. As debentures are unsecured investors buy these securities based on the creditworthiness, financials, reputation, and faith an investor has in the entity issuing it.
However, it is also important to note that the word Debenture may have different meanings in different parts of the world. What we have seen so far represents debentures in India and countries like the US. In the UK however, debentures are unsecured. They represent documents that grant the lenders a charge over the asset. This gives the lenders a means of collecting their money back in the case of a default.
Components to look before investing in a Debenture
Debentures have 3 basic components and they should be looked into carefully before investing in:
1. Credit Worthiness
Since debentures are unsecured instruments it is very important to find out whether the company issuing them will actually be able to repay the debt. One must carefully look into the financials and the track record of the company before investing in them.
Investors can also make use of the credit ratings of the company. These are provided by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings. Ratings are given to the companies based on a scale set by these agencies based on the creditworthiness of the borrower. Companies receiving the excellent rating are good investment option over companies receiving rating lower on the scale
2. Coupon Rate
Another important factor is what returns will the debenture be providing to investors. The coupon rate represents the yield or payment made by fixed income securities on their face or par value. This rate is either fixed or floating i.e. it can be fixed or constant at one rate or set as floating which changes.
3. Maturity Date
The date of maturity is very important when it comes to debentures. It represents the date on or before which the company must pay back the debenture holders. The company may pay back the capital amount raised by debentures on this date which is generally the case. Or the company may pay a specific amount each year until the date of maturity.
Risks Associated with a Debenture
As with every financial instrument, there are also few risks involved with debentures. Since debentures are unsecured they carry the risk of default. Debentures also carry interest rate risks.
Further, as debentures are issued over long periods debenture holders might find themselves receiving lesser returns from debentures over time in comparison to other investment options. It is also possible that the interest rate provided may be overtaken by the inflation rate.
What are the types of debentures?
Debentures can be classified into 2 categories based on their convertibility
1. Convertible Debentures
Convertible Debentures are those which can convert into equity shares of the issuing corporation after a specific period. Here the debenture holders have the option to either hold the debentures until maturity and receive the interest payments on them. Or they can convert the debentures into equity shares.
2. Non-convertible Debentures
Non-convertible debentures (NCD) or traditional debentures are those which cannot be converted into shares or equities. NCD interest rates depend on the company issuing the NCD.
What is the difference between Debenture and bond?
A debenture is an unsecured type of debt issued by a company. They are issued simply based on the creditworthiness of the company.
A bond similar to a debenture is meant for companies and countries to raise capital providing interest in return. Bonds however are secured and backed by a specific asset of the issuer.
In this article, we explained what is debenture. In a nutshell, debentures are an important source of funds for companies. In addition to this, they also have become exceptional instruments used to balance the portfolios of investors.
One however must invest in debentures only after careful evaluation of the creditworthiness of the company and other aspects like coupon rate, expiry date, etc. Hopefully, we were able to answer – what is Debentures. Happy Investing!
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.