A debenture is a way of borrowing money at a fixed or floating rate of interest without assigning any assets of the company as security. Various features of a debenture are the requirement of the trust indenture, payment of coupon interest rate, tax benefit, certain date of maturity, various redemption choices, security, convertibility into equity, mandatory credit rating and claims on profits and assets in case of default.
Definition of Debenture
A debenture is a debt instrument used by the companies to raise money for medium to long term at a specified rate of interest. It consists of a written contract specifying the repayment of the principal and the interest payment at the fixed rate. Generally, a debenture is not secured by any collateral and is only backed by the reputation of the issuer.
A debenture is a document that looks like a certificate stating the indebtedness of the company who has issued it, contains the name of the owner of the certificate who has invested in it and mentions the terms and conditions wherein the coupon rate (interest rate) and the par value of each debenture are also shown.
Features / Attributes of Debentures:
To understand a debenture clearly, it is necessary to understand their features properly. Debentures have certain peculiar features.
It is an agreement which has to be entered into by the ‘Issuing Company’ and the ‘Trust’ which is involved in taking care of the interest of the general investors. For issuing a debenture, it is something mandatory. Normally the trustee is a bank or a financial institution who is appointed by a trust deed.
It is the rate of interest which is promised by the company to pay to the debenture holder on a regular interval which may vary from case to case. The rate of interest may be fixed or floating. The rate of interest which the company opts depends on the credit rating of that company or that specific bond.
Most important element from the company point of view is that the interest paid is a tax deductible expense. Effectively, the company will get the tax benefit because the taxable income will be reduced by the extent of interest paid. Due to this, the effective cost of borrowing gets reduced. Please note the said benefit is there if the company is making profits and paying taxes.
Date of Maturity
For all the non-convertible and redeemable debentures, the issuing company has to issue repayment to the debenture holders on the date of maturity. This date is also mentioned on the certificates and it infers the total time for which the money is invested by the lenders which are interval between the date of issue to the date of maturity.
In essence, a debenture is a debt and it needs to be repaid by a company. There are three choices by which a company may opt to redeem the debentures. One is to make payment on the date of maturity which is the simplest of all and is called redemption out of capital. The second way is to create a debenture redemption reserve wherein the company transfers some fund every year from the divisible profits and this method is known as redemption out of profits. There is another innovative way of redeeming the debentures which are in the form of call and put option. A call option allows the company to buy back its debentures on some agreed terms on or before the maturity. In put option, the choice of redemption is given to the investor.
Here, we should classify debentures into two – secured debentures and unsecured debentures. Secured debentures are secured by some or other immovable assets of the company whereas the unsecured assets are issued based on the general credit of the company. The general legal preference of debt is available to all types of debentures i.e. in the event of liquidation debenture will stand prior to preference shares and ordinary equity shares.
Certain types of debentures are issued with the option of conversion into equity. The ratio of conversion and the time period after which conversion will take place is mentioned in the agreement of debenture. Debentures may be fully or partly convertible in nature.
Normally, an investor would not go and check the credibility and the risk involved with the debentures. Credit rating agencies are given this task and they rate the debentures and the overall company. Involving a rating agency is compulsory for the issuing company normally in every country.
Charge on Assets and Profits in case of Default
The debenture holders may have claims over the profits and assets of the company in case the company has defaulted in the payment of either the interest or the capital repayment.
A debenture is the primary source of long-term capital for companies to fulfil their financial requirements. Other instruments to raise long term capital are bank loans, bonds, and equity shares. Though all these instruments are used widely in different combinations, they differ from each other in many ways. The article clarifies how debenture is different from the bank loan, equity shares, and bonds respectively.
Difference between Debenture vs. Bank Loan
Both debenture and bank loan are ways to finance the long-term debt. However, there are various differences between the two:
- Lending Partner: In debenture, the public lends its money to the company in return for a certificate promising a fixed rate of interest. In loans, the lending institutions are banks and other financial institutions.
- Collateral: Debentures do not require any physical asset or collateral from the firm, whereas banks and other institutions require collateral for the loans unless it is a small amount of unsecured loan.
- Transferability: Debentures can be transferred from one person to another. However, bank loans are non-transferable.
Difference between Debenture vs. Equity Shares
Generally, debentures and equity shares are the two choices sources of long-term capital for the company. These instruments, however, have a lot of differences.
- Ownership: An equity share signifies ownership in the company, whereas a debenture represents a creditor to the company and no participation in the management of the company. The share is a component of the owned capital. The debenture, on the other hand, is a component of the borrowed capital.
- Repayment: Debentures are repayable upon the completion of the issue period. Shares, on the other hand, are not returned during the tenure of the company.
- Priority: In case the company is liquidated, the debenture holders will get the money back prior to the shareholders.
- Return: Debenture holders are paid interest on the debenture and it is not affected by any profit or loss in the company. Shareholders, on the other hand, are paid dividends on the shares from the company’s profits. It is only when the company earns the profit; directors may decide to declare dividends out of the same.
- Risk: Shares are riskier and hence, may be more rewarding as compared to the debentures at times. While the chance of going on the downside for returns is also high.
- The rate of Discount on Issue: Both the instruments can be issued at a discount. Debentures have no limit to the rate of discount, whereas equity shares have a stipulation which limits the discount to 10% in most countries.
- Security: There is no security of any charge on the shares. Debentures, on the other hand, are secured and bear a floating or a fixed charge over the company’s assets.
- Voting Rights: Equity shareholders have the voting rights, whereas the debenture holders do not enjoy voting rights.
- Convertibility: Debentures can be issued to be converted into shares later; called as convertible debentures. However, there is no option for shares to be converted to debentures.
- Mortgage: A company’s assets can be mortgaged in favour of holders of debentures to issue mortgage debentures. However, there is no option of mortgaging assets in favour of equity shareholders.
Difference between Debenture vs. Bond
Debenture and bond are used often as interchangeable terms. However, there are subtle and noteworthy differences between the two instruments:
- Security: A bond is a more secure instrument than a debenture. A debenture does not have any collateral backing; whereas a bond will always have collateral attached.
- Rate of Interest: Debenture holders are entitled to a higher rate of interest in comparison to bond holders. The reason is that debenture is an unsecured loan and therefore, is riskier than a bond.
- Liability: In a case of a bankruptcy, the company is liable to pay bondholders on priority, whereas debenture holders are paid later.
- Periodical Payments: Debenture holders are paid periodical interest on their loan and the principal is paid back at the completion of the entire term. Bondholders, on the other hand, are not paid any periodical payments. They receive the accrued interest and the principal upon the term completion at one go.
A debenture is an important source of raising money for long-term financial needs of the company. Though it raises a considerable proportion of the capital, it is not the only source. Bank loans, equity shares, and bonds are also used by companies to raise money. A company should understand the differences between the various sources of long-term debt and decide the most suitable one after a complete consideration.
There are various benefits and disadvantages of debentures.