Debentures are loans borrowed by the company from the general public. Companies can borrow money from banks, and many companies go to banks as a last resort for funding. But, generally, the banks restrict how that funds can be used, limit the company's potential to raise additional funds until this loan is repaid, etc. Thus, to avoid this, most companies go for a loan from the general public, i.e., Debenture. In this article, we will pen down what are Debentures and why does a company issues Debentures?
Debentures are a type of bond or other debt instruments that is unsecured by collateral. It is a debt instrument that is not collateral and often has a maturity period of more than ten years. In General, companies opt for debentures to raise capital or funds. Some debentures are convertible into common stock, while others are not.
The holders of Debentures have no collateral backing; they must rely on the creditworthiness and reputation of the company. Both corporations and government often issue debentures to raise capital or funds. Therefore, the holders of Debenture are not guaranteed anything other than the credibility and reputation of the issuer.
By purchasing a company's debentures, a person ultimately lends the capital to the company. In return, the company will provide a respective person or firm with a promissory note, this type of note is called a debenture. It guarantees that you will get your principal amount back at the end of a specified period with a fixed interest rate.
When banks lend money to a company, they restrict how the funds can be used. For Instance, funds raised can only be used for capital expenditure. Companies cannot take on additional debt until the current debt is repaid. Thereby, it is far more convenient for the company to raise funds from the general public.
Suppose a company wants to expand the business. The company can opt for Bank Loan. However, the rate of interest is comparatively high. Also, the Banks put certain restrictions on the utilization of Funds.
Through Debentures- The Company can raise capital from small investors in debentures. Thus, instead of paying interest to the Bank. The company will pay the interest to the investors.
All debentures are structured similarly and have similar characteristics. First, a trust indenture is created, a contract between the issuing entity and the entity managing the bondholders' interests. After that, the coupon rate is determined, which is the interest rate that the corporation will pay to the debenture holder or investor. This rate can be fixed or floating and is determined by the company's credit rating or bond.
Rating by Credit Agencies
Credit ratings are evaluated by various agencies to determine the quality of bonds in terms of credit performance. A higher AAA or AAA+ grade is recommended.
This is the interest rate that the issuer is paying. A higher interest rate refers to debt instruments with higher risk, while a lower interest rate refers to debt products with lower risk. Coupons can be paid monthly, quarterly, half-yearly, or annually.
The credibility of the Issuer, The financial condition of the company or issuer, is still the best predictor of goodwill. Knowing why additional funds/capital is needed, as well as the credit rating, are the most important elements to consider when making an investment decision.
These are additional features to promote the product or attract investors, and some of them are offered to A-listers those with substantial financial standing in society. The profit-sharing plan may be offered by a company to employees in the form of a type of debenture.
- Issuance of debentures is one of the most cost-effective ways of raising finance.
- Raising finance through Debentures does not reduce management control. This is because debenture holders do not have voting rights.
- When the company has sued the debentures, they can easily redeem them.
Below mentioned are the advantages of Debentures-
- All debenture holders of the company earn a predetermined rate of return.
- Debentures pay a higher rate of interest than fixed deposit debentures.
- Debentures are liquid securities exchanged on the National Stock Exchange and the Bombay Stock Exchange.
- Several clauses of the trust deed and guidelines set up by the Securities and Exchange Board of India protect the interests of debenture holders (SEBI).
We have talked about the advantages of Debentures. Now here are few of the Disadvantages of Debentures-
- The company's legal obligations include interest rates and principal payments. These should be paid even if there is no profit. This puts a financial burden on the corporation.
- Default payments have a negative impact on the goodwill of the company.
- The assets of the company are pledged to the debenture holders as collateral.
1. Secured Debentures
It is similar to taking a loan to buy an apartment. When you take a home loan, the property is pledged with the Bank as collateral. If you fail to repay the loan, the Bank will take over and sell your property to recover the money.
Similarly, collateral is used to back secured debentures. If the company goes bankrupt, you will be able to recoup your investment by selling the assets.
It is further divided into two parts.
- Fixed charge asset: These debentures are issued against a particular asset. Therefore, they cannot be sold without the consent of the debenture holders.
- Floating charge asset: These debentures are issued against the common assets of the organization.
2. Unsecured Debentures
It is similar to getting a personal loan from a bank. However, in this scenario, there is no collateral. Instead, the Bank gives you money based on your credit score and charges you exorbitant interest rates. Similarly, unsecured debentures are not collateral. Instead, investors invest in them based on the goodwill of the company. As a result, firms pay substantial interest to the holders of unsecured debentures.
1. Convertible Debenture
After a certain time, these debentures are converted into equity shares. They can be fully or partially convertible. Fully convertible debentures are fully converted into equity shares. However, only a part of the partially convertible debentures gets converted into equity.
2. Non-Convertible debenture
In the future, these debentures cannot be converted into equity shares. They have a predetermined maturity date. Depending on the tenure, interest may be paid monthly, quarterly, or annually in addition to the principal amount.
1. Redeemable Debentures
Redeemable debentures are the debentures repayable after a certain period as per the terms of the issue. The date of redemption is specified on the promissory note. These debentures can be redeemed either at par or at a premium.
- Redemption at par: When the redemption value of a debenture is equal to its face value, it is redeemed at par.
- Redemption at a premium: When the redemption value of the Debenture is more than its face value, it is redeemed at a premium. For example, a debenture of Rs 100 is redeemed for Rs 102. Then there is a premium of Rs.2.
2. Irredeemable Debentures
Irredeemable Debentures are also called perpetual debentures. They do not have a maturity date and can be redeemed only when the company is insolvent. Consequently, if the company becomes insolvent, these debenture holders will be the first to suffer.
1. Registered Debentures
The interest in these debentures is distributed to the registered debenture holders. Consequently, in the event of a transfer of ownership, the investor must notify the organization. Otherwise, interest will be credited to the former holder of the debentures.
2. Bearer Debentures
Interest is paid on these debentures to the registered debenture holders. Consequently, the investor must notify the organization in the event of a transfer of ownership. Otherwise, the interest will be credited to the previous holder of the Debenture.
A debenture is treated as a more secure way to invest in a company than purchasing shares because the company must pay the interest on the debenture before making any dividend payments to the shareholders.