The term Debenture comes from the Latin word “debentur” which means borrow. Here, Debentures means a company’s debt. They are one of the most popular debt instruments along with bonds.
When companies or government want to raise their funds from the public, they issue debentures.
Like others, these financial securities are repayable after a certain time period and the company pays the holder a fixed interest at fixed intervals such as quarterly, monthly, and annually.
Generally, the companies pay interest against debentures before paying the debentures.
Salient Features of Debentures
- It is considered an acknowledgement of the debt.
- It is issued by the company under its common seal.
- Debentures can be secured and unsecured.
Types of Debentures
A company has the authority to issue different types of debentures; however, they depend on their objectives and requirements. The classification of a debenture is based on certain things such as security, tenure, coupon rate, redemption mode, convertibility, security, etc.
Two types of debentures are issued by the companies: Convertible Debentures and Non-Convertible Debentures.
Another category of debenture that is also available that is of lesser-known type is a partially convertible debenture. In such cases, the company which issues partially convertible debenture decides the fixed percentage of debenture that may or may not be converted into company stocks.
Let’s get acquainted with some of the most common types of debentures:
There is a type of debentures where the investors have a right to convert their full debenture holdings into equity shares of the company. On a normal note, the rights of the debenture holders, trigger date for conversion, the conversion date is already mentioned at the time of issuing debentures.
Non-convertible debentures are issued by companies that don’t give the option to convert debentures into equity shares.
In the case of registered debenture, the company that issues the debentures takes all the details of the holder such as the name and address of the investors, in the register of debenture, the number of debentures issued by the company to the debenture holder.
Also, known as bearer debentures, unregistered debentures issued by a company allow their holders to not maintain any records. Here, the company pays the principal amount along with the bearer of the debenture irrespective of the name written in it.
Another feature of this type of debenture is easily transferable in the market.
These types of debentures are redeemable where the redeemable date is clearly mentioned on the company’s debenture certificate. Once the redemption date comes, the company is bound to return the principal amount to the debenture holder.
These debentures are the exact opposite of irredeemable debentures where irredeemable debentures have a specific redeemable date, these debentures have no fixed date regarding the payment to the debenture holder. It is redeemable only when the company goes into the liquidation process.
Use of Debentures
The primary reason behind the issuing of debentures is to raise funds from the public. The company uses such funds for several purposes such as the company’s growth and research and development in the market.
Companies prefer issuing debentures over equity shares for two reasons: First, issuing debentures has nothing to do with ownership dilution. Two, the cost of raising funds through debenture is quite cheaper than the cost of raising funds through equity shares.
In many cases, the company issued registered secured NCDs as it protects investors against their investment.
Difference Between Convertible Debentures (CD) and Non-Convertible Debentures (NCD):
Convertible debentures are the debentures that can be converted into equity shares of the company.
Non-convertible debentures are the type of debentures that cannot be converted into equity shares.
Rate of Interest
If we compare the rate of interest between the two, then convertible debentures have a lower interest rate than non-convertible debentures because the holders have the authority to convert them into equity shares.
The non-convertible debentures have a higher interest rate. However, they are less risky than convertible debentures and bonds.
The maturity value of convertible debentures heavily depends on the company’s stock price at the time of issuing the debentures. A higher stock price means higher returns and a low stock price means the company provides fewer returns.
Vanilla convertible bonds give investors a facility to hold the bond until maturity or you can convert it into stocks. If the stock price has decreased since the bond’s issue date, the investors can hold the bond until maturity and get paid the face value.
The maturity value of non-convertible debentures remains fixed as they provide fixed returns on maturity.
Status is the distinguishing factor between convertible and non-convertible debentures. If you hold convertible debentures, you can enjoy either the status of being a creditor of the company or the owner of the company. On the other hand, if you hold non-convertible debentures, your status will be considered as the creditor of the company.
Importance of Debenture as a Source of Finance
Debentures as a source of finance are used by companies that have regular earnings to service the debt and also have a higher proportion of fixed assets in their asset structure that offers proper security.
Also, the company needs to ensure the debt-to-equity ratio.
The recent changes that have been noticed in the issuing of debentures are quite encouraging and promising which are as follows:
- Now, support from investment institutions is available. LIC, UTI, etc. and others have been into this field to invest public funds in debenture issues.
- The emergence of institutions acting as a trustee for debenture holders have reposed confidence in the investing public for the security of their money and safeguard of their interest as creditors.
- Investors preference for high yielding securities with minimum risks has encouraged the issue of debentures.
The Bottom Line
Debentures play a very important role for debentures as it pays them a regular interest rate or coupon rate return to investors. Convertible debentures can be converted to equity shares after a specific period, making them more appealing to investors.