Debentures: Types, Features and Benefits for Companies and Investors

Capital is the lifeline of any business as it represents the funds to run a business. Promoters and founders pitch in with the initial capital investment. 

But as a company grows, the capital requirement also increases. However, it is not possible for promoters to fulfil all the additional capital requirements. 

In such a scenario, there are two ways of raising capital. One is they can sell some of their stakes in open markets by launching an IPO. The other method is to borrow money via debentures and bonds. Read along to learn more about how companies raise money from debentures and fulfil their capital requirements. 

What are debentures?

It is a debt instrument which allows companies to raise money to fund their business activities. This term has its origins in the latin language and is derived from the Latin word debentur, which means to borrow. One major feature of debentures is that, unlike normal loans, it is not necessary to secure a debenture-based loan with collateral. 

Companies can also receive a loan via debentures without pledging any collateral. It comes in the form of a legal certificate. Companies issuing debentures must pay regular interest payments to the lender and the full principal amount on maturity date. 

Some of these instruments also have no collateral requirements. Therefore, these are high-risk alternatives since the investor has nothing to recover if the issuer defaults on interest payments or the principal amounts. Therefore, the company's creditworthiness plays an important role in determining interest rates, repayment periods and other obligations.

Generally, these instruments come with a fixed interest rate. The interest amount can be repaid either on a half-yearly basis, annual basis or quarterly basis. It varies from lender to lender and also the standing of the issuing entity. The legal certificate that carries all the details is called a debenture deed and is issued under the company's seal of authority.  

Now that you are aware of the meaning of debentures let’s shift our focus to other aspects of the same.

Features of debentures

Some features of these debt instruments are as follows: 

• Collateral 
  There are some kinds of debentures which are backed by collateral, whereas there are some which do not come with any collateral. For those instruments that come with collateral, investors are relatively stress-free as they can recover their investment amounts by selling the pledged assets. 
  However, it becomes a bit tricky in collateral-free instruments. In such cases, investors are extra cautious and take into consideration the credit standing or creditworthiness of concerned entities before lending money. 
• Interest rate 
  Issuers are liable to pay coupon payments to the lenders as per the terms of repayment. These payments should be periodical in nature and paid annually, half-yearly or quarterly basis. The coupon rate depends on the creditworthiness of the company, prevailing market interest rates and current economic conditions. 
• Conversion 
  Some debentures come with an option that, after the completion of a specified period, it can get converted into equity stocks. It gives investors an opportunity to get ownership of the company by acquiring a certain percentage of stocks. After acquiring a certain percentage of stocks, they have the opportunity to sell the same when the price rises and earn profits. 
• Repayment tenure 
  The repayment tenure and timeline vary from one debt instrument to another. All these details are clearly mentioned in the debenture deed that both parties sign at the time of borrowing. The principal amount in some of these instruments is paid either in a lump sum manner or part payments. 
• Parties involved 
  There are three parties involved in this process. One is the company that is borrowing the money. The other is a trustee through which companies deal with debenture holders. Companies forge an agreement between concerned trustees and debenture holders. 
  Finally, there are debenture holders who provide funds to the issuing entities. In return, they receive interest payments and the full principal amount. 
• Voting rights 
  One significant feature associated with these debt instruments is that lenders, who are formally known as debenture holders, do not have any sort of voting rights. In very rare cases, companies may ask for opinions on some issues from them. However, it is completely up to the company whether they want to accept the opinion or not.  

Types of debentures

Debentures are classified on the basis of various parameters like security, tenure, and convertibility. The relevant classification is as follows:

Based on Security or Collateral:

• Secured debentures 
  As the name suggests, these debt instruments are backed by definite collateral, which functions as security. The debenture holder reserves a right to liquidate or sell the collateral in case of a default. 
• Unsecured debentures 
  On the other hand, an unsecured debenture does not have any collateral or security associated with it. These instruments come with a higher risk tolerance level as investors do not have anything to liquidate or sell off in case of a default. 
  For these debt instruments, investors and lenders consider the creditworthiness of bondholders before deciding to put their money in the same.

Based on tenure:

• Redeemable debentures 
• This kind of debt instrument comes with a definite redemption date. Bond issuers are legally liable to pay off the complete principal amount on or before that specified date. Debenture deed contains the redemption date. 
• Irredeemable debentures 
• As the name suggests, these debt instruments do not come with any maturity or redemption date. Redemption of these debt instruments happens during the liquidation of the respective bond issuing entities. 

Based on convertibility:

Let’s move on to the different types of debentures on the basis of convertibility. It is a facility through which lenders have the option to convert debentures they are holding into equity shares and become part owners of the company. 

• Convertible debentures 
  These debt instruments have the option of being converted into equity shares. The legal agreement signed between both parties consists of rights of debenture holders, the particular date on which conversion can be triggered and other rules and regulations governing convertibility. 
  These debt instruments have three sub-classifications which are as follows:
• 1. Fully convertible debenture 
     Issuing companies can fully convert the full debenture amount into a proportionate number of equity shares. 
     The debenture issuing entities shall determine the conversion time and date. After the conversion, debenture holders will enjoy equal status as any other shareholder of issuing company.
  2. Partially convertible Ddebenture
     Again, as the name suggests, this type of debenture instrument gets converted into respective equity shares only in a partial manner. 
     The company issuing these instruments decide on the conversion triggering date as well as the final conversion ratio. Holders of this instrument will enjoy the dual benefits of being a shareholder and a creditor of the company at the same time. 
  3. Optionally convertible debenture
     Entities issuing these debt instruments give their corresponding debenture holders an option to convert their debt into equity shares. Issuing entities shall determine the price at which such conversion may take place. Moreover, all the nitty gritty regarding such conversions will be decided at the time of issue. 
• • Non convertible debenture
    This is the second kind of debenture in the convertibility category. As the name goes, these debt instruments do not allow investors to convert their debt into any kind of stake in the company. 
    As these do not come with an option of future conversion, coupon rates on these are high as compared to other debenture categories. This has been done to increase its lucrativeness and attract more investors.

• Benefits of investing in debentures

• Some benefits of issuing and investing in debentures are as follows: 
• 1. Secured investment 
     Some debentures come with collateral attached to it. This gives some sort of leverage to investors that they can recover either part or full obligation in case of a default. 
     This facility provides security to the investors and helps in increasing the trust quotient by giving a guarantee that their money is safe even if the debenture issuer defaults. 
  2. Fixed return 
     Another benefit of debenture is that it comes with a fixed rate of return. Companies are legally liable to pay regular and timely interest payments to the bondholders as per the legal debenture deed. 
     A fixed rate of return can prove to be immensely beneficial when the overall market interest rates are falling, as those who have invested in this instrument will continue to reap greater benefits. 
  3. Non-interference in management 
     A stake sale to venture capitalists and private equity firms gives funding options to companies but it comes at a cost of the investors playing an active part in running the company. This may lead to a conflict of interest with the existing management and promoter groups. 
     Hence, raising necessary capital requirements via the debenture method is quite beneficial as it not only takes care of the funding problem, but the management remains in the hands of existing individuals. 
     This has the potential to reduce conflicts and make boardroom functioning much smoother. 
  4. Economical 
     One of the biggest advantages of raising money through debentures is that it is a cheaper way of raising money as compared to other sources of finance. 
     The bond issuers are in for huge gains if they successfully issue a debenture when the interest rates are quite low, as coupon rates will remain fixed at lower levels. 
  5. Regular income source 
     Investing in debentures also comes with an advantage of a regular income source for investors, unlike equities which do not come with a sustained flow of money. 
     It is quite beneficial for senior citizens as well, or those individuals who cannot actively work as the sustainable flow of income helps them in taking care of their needs.  

Drawbacks of Debentures

These debt instruments come with a range of advantages that have been already discussed above. However, like all investment or capital financing measures, it too has some drawbacks, which are as follows: 

1. Risky venture 
   The risk level of this debt instrument is quite high because of different reasons. Non-collateral debentures come with default risk. On the other hand, it also has interest rate risks. 
   This is because the coupon rates for these are fixed, and if market interest rate rises during the course of the total maturity period, lenders or bondholders miss out on an opportunity to earn profits.
2. Loss for borrowers 
   Another disadvantage of this instrument is that borrowers do not have any flexibility with respect to interest payments. They will have to keep on paying a fixed interest amount, and there is no chance of a moratorium on such payments even when companies are facing troubling times. 
   Moreover, if borrowers miss out on some interest payments, they shall be liable to pay heavy penalties as per the debenture deed signed at the time of taking funds. 
   Taking a holistic view of these environments, there may be a possibility that borrowers may end up repaying a significantly larger amount than what they owed.   

Difference between bonds and debentures

Both of these concepts have very similar characteristics in their work and structure. Bonds are larger concepts, and debentures are only a type of bond. The differences between these two debt instruments are as follows:

Conclusion

Issuing debentures is an efficient means of raising money to meet the different capital requirements of borrowing entities. It comes with an affixed interest component that borrowers are liable to pay at specified time intervals. Make sure to assess the different aspects of this debt instrument before making any investment decisions.