Debenture Fundamentals and Types
Meaning Of Debentures
A debenture is a written instrument issued by a company acknowledging a debt under its common seal. It is one of the principal methods by which a company raises loan capital.
In simple terms, when a company issues debentures, it is borrowing money from the public or specific investors. Debenture holders are creditors of the company, not owners.
A debenture is essentially a promise by the company to repay the principal sum on a specified date (or dates) and to pay interest periodically (usually half-yearly or annually) at a fixed rate, known as the coupon rate.
Key characteristics of a debenture:
- It is an acknowledgement of debt by the company.
- It is a contractual agreement to repay the principal amount on maturity.
- It carries a fixed rate of interest (coupon rate) payable periodically, regardless of whether the company makes a profit or loss.
- It is usually issued under the company's common seal (though no longer mandatory for all documents).
- It may or may not be secured by a charge on the assets of the company.
Debentures are a popular source of long-term finance for companies because they do not dilute ownership (unlike shares) and the interest paid on debentures is a tax-deductible expense for the company.
Distinction Between Shares And Debentures
Shares and debentures are two primary instruments used by companies to raise funds, but they represent different relationships with the company and carry distinct rights and obligations.
Comparison Table: Shares vs. Debentures
| Basis of Distinction | Shares | Debentures |
|---|---|---|
| Status of Holder | Shareholders are owners of the company. | Debenture holders are creditors of the company. |
| Return | Return is called Dividend. It is a share of the company's profit. The rate can fluctuate or be fixed (for preference shares). | Return is called Interest. It is a fixed percentage of the face value (coupon rate). |
| Payment of Return | Dividend is paid only out of profits and is discretionary (for equity shares) or requires sufficient distributable profits (for preference shares). | Interest is a charge against profits and must be paid regardless of whether the company makes a profit or loss (unless specifically agreed otherwise in rare cases like income debentures). |
| Voting Rights | Equity shareholders generally have voting rights. Preference shareholders generally do not, unless their rights are directly affected or dividends are in arrears. | Debenture holders generally do not have voting rights in the company's general meetings. |
| Security | Shares are unsecured. Share capital is the risk capital. | Debentures are usually secured by a charge on the company's assets (though unsecured debentures also exist). |
| Repayment of Capital | Capital is returned only at the time of winding up of the company (after repaying creditors and preference shareholders), or through buyback. | Principal amount is repaid after a specified period (maturity date) or at the time of winding up (before shareholders). |
| Nature of Capital | Represents Owner's Fund or Shareholder's Equity. | Represents Borrowed Fund or Debt Capital. |
| Priority of Repayment | Rank last for repayment of capital and arrears of dividend during winding up (after preference shareholders). | Rank before shareholders for repayment of principal and interest during winding up. |
| Tax Treatment of Return | Dividend is generally paid out of after-tax profits. (Taxation rules on dividends have changed over time in India). | Interest paid is a tax-deductible expense for the company, reducing its taxable profit. |
| Governing Act/Section | Governed by provisions relating to Share Capital, Issue of Shares, etc. (e.g., Sections 43-72 of Companies Act, 2013). | Governed by provisions relating to Debentures (e.g., Sections 71 of Companies Act, 2013). |
Types Of Debentures
Debentures can be classified into various categories based on different criteria:
From The Point Of View Of Security
1. Secured Debentures
These debentures are secured by a charge on the assets of the company. In case the company fails to pay interest or principal, the debenture holders can sell the charged assets to recover their dues. The charge can be:
- Fixed Charge: Created on specific, identifiable assets (e.g., a particular piece of land or building). The company cannot sell or deal with these assets without the permission of the debenture holders or debenture trustee.
- Floating Charge: Created on the general assets of the company (e.g., inventory, receivables, etc.) which change in the ordinary course of business. The company is free to deal with these assets until an event occurs that crystalises the floating charge (e.g., winding up of the company, default in payment). Upon crystalisation, the floating charge becomes a fixed charge on the assets existing at that time.
In India, most companies issue secured debentures as per the requirements of the Companies Act, 2013, and SEBI guidelines, especially when offered to the public.
2. Unsecured Debentures (or Naked Debentures)
These debentures are not secured by any charge on the assets of the company. They are mere acknowledgements of debt based on the company's creditworthiness. The holders of such debentures are treated as ordinary unsecured creditors.
Companies may issue unsecured debentures in the form of bonds to the public or privately, provided they have a strong financial standing. In India, the issue of unsecured debentures or bonds to the public requires specific conditions to be met.
From The Point Of View Of Tenure
1. Redeemable Debentures
These debentures are repaid by the company after a fixed period, or at any time after giving due notice, according to the terms of issue. The redemption can be done in a lump sum at maturity or in instalments over a period.
Most debentures issued by companies are redeemable debentures.
2. Irredeemable Debentures (or Perpetual Debentures)
These debentures are not repayable during the lifetime of the company. They are repaid only when the company is wound up or in the event of a breach of any condition. Interest on these debentures is paid throughout the life of the company.
In India, perpetual debentures are not common and face regulatory restrictions.
From The Point Of View Of Convertibility
1. Convertible Debentures
These debentures give the holder the right to convert their debentures into equity shares (or sometimes other securities) of the company after a specified period or on a future date, at a predetermined price or conversion ratio. Convertible debentures can be:
- Fully Convertible Debentures (FCD): The entire value of the debenture is convertible into equity shares.
- Partially Convertible Debentures (PCD): Only a part of the debenture value is convertible into equity shares; the remaining part is redeemed as a non-convertible debenture.
- Optionally Convertible Debentures (OCD): The holder has the option to convert the debenture into shares or get it redeemed.
Convertible debentures are attractive to investors as they provide the safety of a debt instrument with a fixed return, along with the potential upside of participating in the company's growth by converting into equity.
2. Non-Convertible Debentures (NCD)
These debentures do not carry any right of conversion into equity shares or any other securities of the company. They are purely debt instruments that are redeemed on maturity.
Investors in NCDs are interested in fixed income and capital protection rather than participating in equity value appreciation.
From Coupon Rate Point Of View
1. Specific Coupon Rate Debentures
These are debentures where the rate of interest (coupon rate) is predetermined and fixed for the entire tenure of the debenture. For example, 8% Debentures means interest will be paid at 8% per annum on the face value.
2. Zero Coupon Rate Debentures (or Deep Discount Bonds)
These debentures do not carry a specified rate of interest. Instead, they are issued at a significant discount to their face value, and the difference between the face value and the issue price is the total interest earned by the investor over the tenure. For example, a debenture of ₹1,00,000 face value might be issued at ₹60,000 and redeemed at ₹1,00,000 after 5 years. The ₹40,000 difference is the interest.
3. Fluctuating Rate Debentures
The interest rate on these debentures is not fixed but is linked to a market rate (e.g., bank rate, repo rate) and changes as the benchmark rate changes.
From The View Point Of Registration
1. Registered Debentures
These are debentures where the names, addresses, and particulars of holdings of the debenture holders are recorded in a register maintained by the company. Interest and principal payments are made only to the registered holders. Transfer of registered debentures requires registration with the company.
2. Bearer Debentures
These debentures are payable to the person who holds them (the bearer). There is no record of the holder's name in the company's register. Interest is paid by means of coupons attached to the debenture, which the holder detaches and presents to the company or its bank for payment. Bearer debentures are transferable by mere delivery.
Registered debentures are more common in India than bearer debentures due to security and regulatory requirements.