What are Debentures?

26 Mar 2021  Read 998 Views

Tired of old stuff? Wanna try something new? Then, why not debentures? Stocks, mutual funds and bonds are the most common form of investment options we were offered with. But there is also another less known investment path -- debentures. 

While many of us have come across this term one way or the other, we hardly know how it can help in boosting your returns. So today, we will dive into this concept and decode everything about debentures. 

Understanding Debentures in Brief

Debentures are a form of promissory notes which the company issues in order to raise capital from the general public. A company usually resorts to debentures as the terms and conditions can be put forth as per the company’s will, unlike in the case of bank loans where the banker says everything, from interest rates to repayment period. 

Debentures are identified by the following two features:

  • Comparatively lower interest payment
  • Longer repayment period

Debenture holders are given priority over the Preference Share and Equity Shareholders. Be it in terms of payment of interest or during the time of liquidation; the debenture holders are given the first priority before all the shareholders. To add on, the debentures issued are not backed by security in most cases. Hence, it all drives down to the creditworthiness, reputation, maturity period and interest or coupon rate. 

Debentures vs Stocks vs Bonds

Having got a bird’s eye view into what a debenture is, let us see in detail as to how it differs from the rest of the asset classes.

Particulars 

Debentures 

Bonds 

Stocks 

Meaning

Debenture constitutes the debt obligation of a company. 

Bonds, on the other hand, are instruments which symbolise the indebtedness of the issuer towards the holder.

Stocks are instruments that enable the investor to hold a part of the company.

Issuers

Debentures are usually issued by large creditworthy institutions or companies. 

The government and other financial institutions are the ones that issue bonds. 

Every listed company can go in for a public offering of its shares. 

Risk of the instrument 

The risk factor is comparatively higher than bonds as the company can face a crisis at any time putting into question the repayment of the loan capital. 

The risk factor is extremely low as it is a government entity. 

Shares are the riskiest among the three.

Security 

Debentures are not offered against an underlying security. But it is opted based on the creditworthiness of the company and coupon rates. 

Bonds have a security against which the holder lends money. 

The concept of security does not come into play here. 

Interest rate and returns 

The interest or coupon rate one gets will depend and vary from company to company based on their creditworthiness, reputation and risk involved. Higher is the risk, the higher the returns. 

Bonds in most cases offer lower interest as the risk factor is low.

Returns totally depend on the company you choose and various other internal and external factors. While there is no predetermined rate as such, when invested properly following a particular strategy, returns can be maximised.

Types of debentures 

Debentures can be broadly classified under the following heads --

Redeemable and Irredeemable debentures 

Redeemable debentures, as the name itself imply, can be redeemed after a specific period of time, say, 5 or 10 years. Irredeemable debentures, on the other hand, can only be redeemed at the will of the company. For instance, say you have brought the debentures of company XYZ. Now the maturity period is not predetermined as in the case of redeemable debentures. You cannot force the company to pay back the capital. The company can opt to pay back as per their will. Payback mostly happens during the time of liquidation. Having said that, irredeemable shares are not prevalent in India.

Convertible and Non-convertible debentures

In some cases, the debenture holders are offered a chance by the company, wherein they can change their securities into shares after a particular period of time. These debentures are known as convertible debentures. Those debentures which do not hold such a feature will be known as non-convertible debentures.

Secured and Unsecured debentures 

When the debentures are issued against an underlying asset, they’re called secured debentures. In the absence of such an asset, the debentures can be called as unsecured debentures. 

For these sort of debentures, the interest rate can either be fixed or floating. What are they? Read to find out.

  • When the underlying security is fixed at the time of issue, it is called fixed interest. The company cannot sell the asset. But it can be used for the ordinary business of the company.
  • In the case of floating rates, there is no specific asset the company will place for raising the funds. It will change the underlying security from time to time. However, at the time of liquidation, by default, it becomes fixed.

Advantages of debentures

Debentures, as such, happen to be one of the best tools available in the market when considering a long term investment option. A company will find debentures more suitable than a bank loan, owing to the long period it gets to repay and a relatively lower rate of interest. In addition to that, the company can also avoid dilution of ownership as the debentures constitute only a part of the loan capital of the company and not the ownership. 

From the point of view of investors, it offers a stable income at a relatively lower risk. Retired individuals and people with a low-risk profile can opt for these instruments. Further, if you are looking to diversify your portfolio, then holding about 5-10% of your capital in debentures and bonds might help.

To conclude

Now you know what debentures are and how they will aid your portfolio. They are perfect lifesavers when you are looking for a stable income or simply trying to dilute some risk. So, it’s time you start thinking about whether it will fit into your portfolio or not.

About the Author: Varishika Dinesh | 136 Post(s)

Varishika is on the verge of successfully completing B.Com. Nothing excites her more than reading books and watching movies. Business, finance, economy? You have her attention.

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