Debentures: Meaning, Features, Types, Advantages & Limitations

 Debentures

Debentures are creditorship securities that represent the long-term indebtedness of a company. A debenture is an instrument executed by a company, usually under its common seal, acknowledging its indebtedness to one or more persons for a specified sum of money borrowed. Thus, a debenture is a security issued by a company in consideration of a loan.

A public limited company is permitted to raise funds through debentures after obtaining the Certificate of Commencement of Business, provided such borrowing is authorised by its Memorandum of Association. The Companies Act, 2013 does not specifically define the term “debenture.”

Debentures, like shares, represent equal units of a loan raised by a company. They are generally secured by either a fixed charge or a floating charge on the assets of the company. Debenture-holders are entitled to receive interest at a fixed rate, payable at regular intervals, usually every six months. The company also undertakes to repay the principal amount on the expiry of the stipulated period, in accordance with the terms of issue.

Similar to shares, debentures may be issued at par, at a premium, or at a discount. Debenture-holders are creditors of the company and therefore do not possess voting rights. However, their claims rank prior to those of preference shareholders and equity shareholders in the event of liquidation. The rights of debenture-holders vary depending on the nature and terms of the debentures issued.

Features of Debentures

1. Interest Rate Debentures carry a fixed rate of interest, which is payable at regular intervals, usually half-yearly or annually, irrespective of the company’s profits. This provides a stable and assured return to debenture-holders.
2. Maturity Debentures are issued for a specified period and have a definite maturity date on which the principal amount becomes repayable, unless they are perpetual in nature.
3. Redemption Redemption refers to the repayment of the principal amount of debentures at maturity. It may be carried out through:
• Sinking Fund: A fund created by the company by setting aside profits periodically to ensure the availability of funds for redemption.
• Buy-back (Call) Provision: A clause allowing the company to redeem debentures before maturity at predetermined terms.
4. Indenture (Debenture Trust Deed) An indenture, also known as a debenture trust deed, is a legal document that specifies the terms and conditions of issue, rights of debenture-holders, rate of interest, security offered, and duties of the trustee.
5. Security Debentures may be secured or unsecured. Secured debentures are backed by a fixed or floating charge on the assets of the company, while unsecured (naked) debentures carry no such charge.
6. Yield Yield refers to the effective rate of return earned by a debenture-holder, considering the interest received, purchase price, redemption value, and time to maturity.
7. Claims on Assets and Income Debenture-holders have a prior claim over shareholders on both the assets and income of the company. Interest on debentures must be paid before any dividend is declared, and their claims rank ahead of preference and equity shareholders in the event of liquidation.

Classification of Debentures

1. Non-Convertible Debentures (NCDs) non-convertible debentures are those debentures which cannot be converted into equity shares of the company. They remain as debt instruments throughout their tenure and are redeemed on maturity. NCDs provide a fixed rate of interest and are preferred by investors seeking stable income with lower risk.
2. Fully-Convertible Debentures (FCDs) Fully-convertible debentures are debentures that are entirely converted into equity shares of the company after a specified period. After conversion, the holder becomes a shareholder and ceases to be a creditor. These debentures usually carry a lower rate of interest because of the conversion benefit.
3. Partly-Convertible Debentures (PCDs) Partly-convertible debentures are those in which a portion of the debenture value is converted into equity shares, while the remaining portion continues as debt and is redeemed at maturity. The terms of conversion, including the ratio and timing, are specified at the time of issue.

Types of Debentures

Debentures can be classified into the following types:

1. Redeemable and Irredeemable Debentures

Redeemable Debentures are those which are repayable after a specified period, as mentioned in the terms of issue. Redemption may take place:

• At the end of a fixed period,
• At the option of the company by giving due notice to debenture-holders, or
• By instalments, in accordance with the terms of issue.

Irredeemable Debentures, also known as Perpetual Debentures, do not have a specified date of redemption. These debentures are repayable only on the winding up of the company or in the event of default in payment of interest. Debenture-holders cannot demand redemption during the company’s normal existence.

2. Secured and Unsecured Debentures

Secured Debentures, also known as mortgaged debentures, are backed by a charge on the assets of the company. The charge may be:

• Fixed charge on specific assets, or
• Floating charge on all or a class of the company’s assets.

Unsecured Debentures, also called simple or naked debentures, are not secured by any charge on the company’s assets. The holders rely solely on the general creditworthiness of the company.

3. Registered and Bearer Debentures

Registered Debentures are those which are registered in the books of the company. The name, address, and details of the debenture-holders are recorded in the company’s register. Transfer of registered debentures requires a duly stamped and properly executed transfer deed. Interest is paid only to the registered holders.

Bearer Debentures are transferable by mere delivery and do not require registration or notice to the company. The company does not maintain records of bearer debenture-holders. Interest coupons are attached to the debenture certificate, and interest can be claimed by the holder of the coupon.

4. Convertible and Non-Convertible Debentures

Convertible Debentures are those which can be converted into equity shares or preference shares of the company after a specified period, as per the terms of issue. A company may also issue partly convertible debentures, under which only a portion of the debenture amount is convertible into equity shares.

Non-Convertible Debentures (NCDs) are debentures which cannot be converted into shares and are redeemed at maturity. They remain pure debt instruments throughout their tenure.

Advantages of Debentures

1. Less Costly Debentures are generally a cheaper source of finance compared to equity, as the rate of interest is usually lower than the expected return demanded by shareholders. Moreover, interest on debentures is tax-deductible, reducing the overall cost.
2. No Overall Dilution of Control Since debenture-holders are creditors and not owners, the issue of debentures does not dilute the ownership or control of existing shareholders.
3. Fixed Payment of Interest Debentures carry a fixed rate of interest, providing certainty regarding the company’s financing cost and offering stable income to investors.
4. Reduced Real Obligation The real burden of repayment is reduced over time due to inflation, as both interest and principal are paid in fixed monetary terms.

Limitations of Debentures

1. Obligatory Payment Payment of interest on debentures is a legal obligation, irrespective of the company’s profitability. Failure to pay interest may lead to legal action or winding up.
2. Financial Risk Excessive reliance on debentures increases the financial risk of the company due to higher fixed financial charges.
3. Cash Outflows Regular interest payments and eventual repayment of principal lead to continuous cash outflows, which may strain liquidity.
4. Restricted Covenants Debentures often contain restrictive covenants that may limit the company’s freedom in matters such as further borrowing, dividend declaration, or disposal of assets.

FAQ on Debentures

What are debentures?

Debentures are long-term debt instruments issued by a company to raise funds. They represent a loan taken from investors, who receive periodic interest and repayment of principal on maturity. Debenture-holders are creditors, not owners, and generally have no voting rights.

What are the main features of debentures?

Key features of debentures include a fixed interest rate, specified maturity, redemption terms, security (secured or unsecured), yield, and claims on the company’s assets and income.

What are the advantages of debentures?

Advantages of debentures include lower cost of finance, no dilution of ownership, fixed interest payments, and reduced real burden of repayment over time.

What are the limitations of debentures?

Limitations include obligatory interest payments, increased financial risk, continuous cash outflows, and restrictive covenants imposed by debenture terms.

Can debentures be converted into shares?

Yes, convertible debentures can be converted into equity or preference shares after a specified period. Non-convertible debentures cannot be converted and remain debt instruments until redemption.

Are debenture holders considered company owners?

No, debenture-holders are creditors of the company. They do not have voting rights and have a priority claim over shareholders on assets and income.

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