The term Debenture comes from the Latin word “debentur” which means borrow. Debentures are one of the types of bonds that government entities or corporations use to raise capital. They are one of the most popular debt instruments along with bonds.
While all debentures are bonds, not all bonds are debentures. The biggest difference between is, how they’re collateralized. It’s interesting to understand how they work and how they are different compared to the traditional bonds.
What are Debentures?
A Debenture generally refers to a document that is issued by the company as evidence of its debt towards the debenture holders at a fixed rate of interest. In layman terms, you can mark the debenture document as the acknowledgment receipt of the company’s indebtedness towards its holders. Debentures are also known as the bond, which is generally an IOU (I Owe You) between the borrower and the lender.
Debentures are also a creditorship instrument as the holders of the debentures are the creditors of the company. Interest on the debentures is also required to be paid by the companies to the holders at the pre-agreed time intervals, i.e. whether for profit or loss the company must pay interest to the debenture holders.
What are the Different Types of Debentures?
1. Based on Security
1.1 Secured Debentures
The debentures which are secured fully or partially by a fixed (e.g. charge on specific assets land, building, etc.) or floating charge (e.g. a charge on all company assets in general) on the company assets are known as the secured debentures.
1.2 Unsecured Debentures
The debentures which carry no security (full or partial) over the company assets are known as the unsecured or naked debentures. Such debenture holders are known as the unsecured creditors.
2. Based upon Redemption
2.1 Redeemable Debentures
Redeemable debentures are the ones which are payable after a specific time interval as per the pre-decided terms. Sometimes such debentures can be redeemed early by the holders as per the company’s discretion.
2.1.1 Call and Put Options:
Some companies issue debentures with call or put options for redemption.
Typically the call option enables companies to redeem or buy back their debenture before the maturity date at a predetermined price. On the other hand in the put option, debenture holders avail the right to sell the debenture back to the company at an agreed price, before the maturity date.
2.2 Non-Redeemable Debentures
These debentures are also known as the perpetual debentures and are not repayable during the lifetime of the company along with no obligation from the company’s side to pay the principal amount of the same. They sometimes carry call/put options.
Features of Debentures
- Credit Rating
The company that issues debentures has to approach credit rating agencies such as CRISIL, CARE, ICRA, etc., for ratings. It plays a significant role in determining the creditworthiness and the potential of the company to fulfill its obligations towards the creditors. A company with high credit ratings implies fulfilling its obligation, whereas a lower credit rating company has higher credit risk. Thus, if the issuing company defaults payments, the agency will downgrade its rating.
- Interest Rate
The interest rate offered by a debenture is generally higher than that of a fixed deposit. Also, the interest rates of unsecured debentures are the highest. They have the flexibility of interest payments either monthly, quarterly, half-yearly or annually. Furthermore, they have a cumulative payout option as well.
The taxation of NCD is the same as debt taxation. If the investor sells the NCD within three years, then STCG will be applicable as per the income tax slab rate. Subsequently, if the investor sells the NCD after three years, LTCG will be applicable at 20% with indexation.
Further, the government has on occasion issued itself or through it’s various entities issued bonds/NCDs that are exempt from tax, and are referred to as tax free bonds.
How Debentures Work?
- Debentures are often issued when a corporation or government needs to raise capital for a specific purpose. For example, a city government may need funds to move ahead with a sewage water cleaning project while a corporation may require capital to complete scaling it’s manufacturing unit project. In these types of scenarios, debentures can act as a form of long-term financing.
- When a debenture is issued, it can offer a floating or fixed-interest rate for investors. When it’s time to repay the principal on debenture investments, issuers can choose between lump-sum payments or may choose to repay in installments.
- In some instances, companies may allow investors to convert their debenture into shares of stock. Convertible debentures may be attractive to investors who are interested in eventually owning an equity stake in the company.
- Debentures can be an attractive option for raising capital when a corporation or government would prefer not to use existing assets as security for traditional bonds. Companies may also rely on debentures to raise capital if they’ve already pledged all available assets as collateral elsewhere. Because they often have longer repayment windows and lower interest rates, debentures may be more attractive than other types of long-term financing.
Difference Between Debentures And Bonds:
Again, all debentures are bonds, but not all bonds are debentures. While traditional bonds are collateralized, meaning there’s some type of security behind them, debentures are backed only by the trust of the entity that issues them. Corporations and governments can issue both bonds and debentures. With bonds, the investor has the promise of receiving repayment on their principal, along with interest payments. But in case the bond issuer defaults on that promise, there’s underlying collateral that could be used to repay what’s owed to investors.
Generally speaking, bonds and debentures are safer investments than individual stocks or mutual funds. That’s because bonds can offer a stable or guaranteed rate of return over time. Debentures can be riskier than bonds for investors because there is no collateral in place, though not all debentures are the same in that regard. Sorting through all the debt securities options that are out there are as straightforward as it looks; your financial advisor from ShareIndia can help you find which ones work best for your own tailor made financial plan.
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Disclaimer: Any Advice or information in the post is a general advice for education purpose only and is not responsible for generating any trading strategy for anyone, please do not trade or invest based solely on this information.