If the risky stock market shares haunt you and you are looking for a less risky investment, company debentures can be your go-to choice.
Company debentures mainly work on the creditworthiness of the issuer/authorities and yield a fixed rate of interest. Businesses and corporations issue debentures for long-term activities and growth to raise capital or funds.
In corporate finance, company debentures are marketable security that authority bodies issue when they seek to borrow funds from the public at a predetermined rate of interest.
When the company’s assets back company debentures, it is called a mortgage or secured debentures.
An example of secured debentures is debentures backed by any of the company’s assets, such as the factory building of that concerned company.
A company’s share capital does not allow money raised by debentures to be parked into a company’s capital structure.
As a result, a debenture is treated as a loan or debt certificate confirming the entity’s obligation to pay a fixed rate of interest. Hence, debenture holders are the entity’s creditors, making company debentures safer than stocks.
Let us proceed step by step to understand the company’s debenture clearly. The first aspect is understanding the meaning of a company debenture.
A company debenture is a debt instrument that is not backed by any collateral security medium for a long term period. It delivers interest on a fixed rate and can be redeemed at the maturity date with the pre-decided price.
Company debentures are like long-term loans. But, they are not secured with any assets. A company issues debentures to gain funds.
There are three parties associated with a Debenture, and they are:
A company is a party that borrows the money in return for the debenture certificates.
A debenture holder is an individual who has provided a loan to the company in return for a debenture certificate.
A trustee is a middle entity through which the company deals with debenture holders, and the company forms an agreement between the debenture holders and the trustee.
This agreement is known as the Trust Deed, and it comprises details like obligations of the company, rights of the holder, etc.
Let us understand company debentures with the help of a suitable example. A perfect example of debenture could be a government-issued treasury bill. Treasury bills are money market securities used to raise funds to meet short-term obligations. The Reserve Bank of India issues these bills on behalf of the central government.
In simple words, Treasury bills are loans given by the public to the government. The public buys this zero-coupon security at a discounted price and redeems it with the total face value decided by the government.
The security is risk-free as they are backed by the supreme authorities in India. But, these securities might not give enough returns to sustain inflation or market rise.
Company debentures are a lucrative tool for investment. When issuing a debenture, trust indentures are necessarily required to be drafted. Some of the critical features of debentures are as follows:
A debenture is a written commitment that states a specified amount of money promised to the debenture holder by the company issuing them.
A debenture has a face value of higher denominations of INR 100 or its multiples.
Debentures are issued with a maturity date by any company. Maturity dates are mentioned in the certificate.
It is a debt instrument. Hence, the company is supposed to pay the whole amount during the maturity date and interest for the entire period.
A debenture holder is a creditor to the company and does not imply company ownership. The money owed by the company is to be paid during the maturity period.
Unlike equity shareholders, debentures do not enjoy voting rights or control over the management of the issuing authority. As we already know, they are viewed as creditors, not owners.
The issuing company promises the debenture holders’ interest in their debentures. The interest is paid periodically on a half-yearly or annual basis, depending on the company.
The interest rate on debentures is different for different companies due to differences in business. The rate of interest is also dependent on fluctuating market conditions.
Investors view debenture as a prioritised investment option as the return is determined at a fixed rate. The investment is secured, irrespective of incurred losses or profits made by the company. The entity is legally bound to pay back its holders at the predetermined interest rate.
At maturity, the debenture holders receive the principal amount and the total prescribed interest mentioned in the debenture certificate.
During the liquidation of an entity or company, debenture holders are preferred before equity shareholders in terms of repaying the borrowing amount.
Debentures can be redeemed at par, premium or discount, depending on the financial position of the issuing company or the selling decisions of the debenture holder in the secondary market.
It is mandatory for a debenture to be listed on at least one stock exchange.
Company debentures can be classified into several categories, and the different types of debentures are as follows:
One can categorise company debentures based on convertibility into two types:
Convertible debentures are those where holders of a particular company have the right to convert their debenture holdings into equity shares of that specific company.
The company specifies the terms and conditions when issuing convertible debentures, date of conversion, holders’ rights, etc.
Convertible debentures can be further classified into three types, and they are as follows:
These debentures are like traditional debt instruments that do not have the right to convert into equity share capital. However, the interest yield on such debentures is higher than its regular counterparts.
One can classify company debentures based on security into two types:
These debentures are backed against the assets of the concerned entity. Even if the company declares itself insolvent, the amount needs to be paid by selling off the company’s assets and property.
When the issuing company’s assets are held with security, it is called fixed charge debentures.
Secured debentures are further subdivided into two categories, and they are as follows:
The company’s credibility is crucial in issuing unsecured debentures, not carrying any security or assets backed by the concerned company.
With the terms and conditions in line, the interest rates are comparatively higher in most cases of unsecured debentures.
One can classify company debentures based on redemption into two types:
Redeemable debentures enable the debenture holder to redeem their debenture certificate on the maturity date and receive the agreed-upon payout.
Unlike redeemable debentures, irredeemable debentures or perpetual debentures are those debentures that the debenture holders cannot redeem. These debentures do not have a maturity date.
Such debentures can only be redeemed when the company is insolvent and decides to liquidate its assets or if the debenture contract has stated a condition for redemption.
This uncertainty in redemption can let these debentures exist perpetually. Hence, they are also called perpetual debentures.
Note – Irredeemable debentures are banned in the Indian security market.
One can classify company debentures based on registration into two types:
Registered debentures are those debentures that are registered under an individual debenture holder. These debentures are issued to a debenture holder in exchange for their credentials like name, bank details, residential address etc.
Debenture holders of sister debentures are legally enrolled with the issuing company. Hence, it is not easy to transfer registered debentures to another individual because the company will be paying interest to the registered person.
Debentures are those debentures that do not require any registration. These debentures can be transferred easily to any holder as the company does not have the credentials of the debenture holder.
The interest on such company debentures is paid by exchanging the coupon attached to the debenture certificate.
Here are a few key benefits of being a Debenture holder:
Now, coming to the other side of company debentures, here are a few demerits of a debenture.
Debenture stocks and company debentures are two different things. But, most of the time, they get the same treatment.
Company debentures are the debt instruments used by a company to generate funds.
However, debenture stocks are contractual. It is an agreement of loan between the issuing company and debenture stockholders. This contract states that the debenture stockholders will be paid dividends at already decided intervals from the company’s earnings.
Debenture stocks have similar fundamentals to preference shares, and they are also risky, just like any other equity.
But, a trust deed is in place to save their day. This deed protects the interest of the stockholders by allowing them to appoint receivers who will aid the safekeeping of their money by helping them in realising the assets.
Overall, company debentures are risk-free securities with fewer chances of money loss. The interest rate on debentures is fixed, irrespective of the profit and loss-making of the issuing company.
They are also prioritised over equity and preference shareholders during the company’s insolvency.
If a company is constantly issuing debentures, it may disable its balance sheet, leading to a fall in its creditworthiness.
There are certain risks that a debenture holder might face after deciding to invest in debentures, and they are as follows:
Inflation is an ever-increasing measure, and it increases with time and reduces the time value of money.
The real motive behind every investment is two-fold. The first one is to book profit and the second one is to beat inflation. It has been necessary to keep up with inflation to avoid losing the time value of money.
Therefore, when the interest rate is less than the inflation rate, the debenture holder can visualise a net loss on their investments.
For example, inflation is 4 per cent which means the prices in the economy are increasing by 4 per cent. However, the debentures have an interest rate of 3 per cent. This difference substantiates that the amount invested in debentures will experience a loss of one per cent in terms of the time value of money.
The interest rate on debentures is fixed. Hence, if the debenture holder is holding the debenture during a rising market, they may feel disheartened that the market gives more return than debentures on the same amount. This can be a loss for investors expecting a high yield rate from the debentures.
The debentures are low-risk securities as they promise fixed returns. But, there is an underlying risk to the creditworthiness of the issuing company. If the company is struggling financially, it can turn out as a defaulter at any moment. The only benefit for a debenture holder would be repayment before the shareholders, whatever it may be during a case of bankruptcy.
Let us explain the difference between shares and company debentures with the help of a comparison chart.
S.no. | Basis | Company debentures | Shares/Stocks |
1 | Definition | Company debentures are debt instruments issued by a company to borrow funds from the public. | Shares are funds raised by providing ownership into the companies’ assets. |
2 | Status | An investor who buys company debentures of a company is called a debenture holder, and debenture holders are known as the company’s creditors. | An investor who buys stocks of a company is called a shareholder, and shareholders are known as the company’s owners. |
3 | Security | Company debentures are secure in terms of return on investment, and they have fixed returns irrespective of the company’s profitability. | Shares are not secure in terms of return on investment, and the dividends on shares are based on the company’s profitability. |
4 | Interest rate | Company debentures have a fixed interest rate. | Shares do not have any interest rate for dividends. |
5 | Earnings | Debenture holders earn even if the company is not making any profit. | Shareholders’ earnings are highly based on the profit-making of the company. |
6 | Voting rights | Debenture holders are creditors of the company and do not get a say in the decisions made by the management. Hence, debenture holders have no voting rights or control over the company. | Shareholders are owners of the company and can take an active part in the decisions made by the management. Shareholders have exclusive voting rights and control over the company. |
7 | Conversion | Company debentures can be converted into shares if they are convertible debentures. | Shares cannot be converted into debentures. |
8 | Trust deed. | When a company issues company debentures, they form a trust deed that states the agreement’s details. It is mandatory to be circulated among the debenture holders.
This deed is used to protect the interest of debenture holders when there is no collateral against the loan. |
Shares do not have anything known as a trust deed. |
Final thoughts
Company debentures are safe debt instruments. Though not entirely safe but better than stock market shares. An investor looking to invest in less risky financial instruments with substantial returns should consider company debentures as its investment choice.
Debentures are a categorisation of the bond. It is debt issued without any collateral. It is also less secure than the bonds because it solely depends on the solvency of the issuing company. If the issuing company faces financial struggles, the debenture might also default.
Company debentures are obligations of the issuing company, and they are prioritised over all types of shareholders, equity and preference.
Hence, if a company goes bankrupt, debenture holders will be paid before shareholders.
Because debentures are debt securities, they tend to be less risky than investing in the same company's common stock or preferred shares. Debenture holders would also be considered more senior and prioritise those other types of investments in the case of bankruptcy.
Hence, debentures are more secure than other investments made in the stock market. But, they are riskier than secured debts. Secured debts are backed by collateral and are risk-free securities.
A Treasury bill is also a type of debenture not secured by any collateral. But, it is considered risk-free because the central government backs it. Hence, the issuing company also plays a vital role in the risk status of a debenture.
Every debenture has a standard process and some typical features. The first and foremost process to draft a trust indenture.
Trust indenture is a term of the agreement between the issuing company and trustee. Now, after this process, the coupon rate is decided. The coupon rate is the interest rate at which the company agrees to give interest to the debenture holders.
The rate depends on the company's creditworthiness, and it can be fixed or floating.
The company also allows the debenture holders to convert the company debentures into shareholders' stock. But, this option is valid only for convertible debentures, and Non-convertible debenture holders cannot avail themselves of this option.
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