Types of Debentures
Debenture (Greek word) means you owe something and is derived from Latin word “debere” meaning “to borrow”. It is a written certificate/instrument signed by the company under its common seal acknowledging debt due by it to its holders. In simple words, through this document:
- Company promises to pay a specific amount of money as stated
- At a fixed date in future
- Along with periodic interest payment
- To compensate holders for using their funds.
A debenture is a debt instrument similar to a bond. But bonds are secured while debentures are not. However, many people use both the terms interchangeably.
Advantages/Merits of Debenture Issue:
- It enables a company to raise funds for a specific period.
- No dilution of control as debenture holders don’t possess voting rights
- Debenture (debt) enables the company to Trade on equity. It can pay dividend to equity shareholders at a rate higher than overall ROI.
- Debenture holders entitled to a fixed rate of interest. Eg: 10% debenture
- They enjoy priority over other unsecured creditors with respect to debt repayment.
- Suitable for conservative investors who seek steady ROI with little or no risk.
- Interest on debentures is treated as expense and is tax deductible.
- Company can adjust its gearing in accordance to its financial plan.
- Debenture holders are regarded as creditors of the company and they receive preference over equity shareholders and preference share holders.
Disadvantages/Demerits of Debenture issue:
- They have a fixed maturity; hence provision has to be made for repayment.
- There is a limit to which funds can be raised through debentures.
- It is risky if the company fails to pay interest or principal installment on time, as debenture holders can file petition for winding up the company.
- It is not suitable for a company with fluctuating earnings as it may also lead to fluctuations in payment of dividend payable to equity shareholders.
- With more risk, you get more return. Debentures being secure investments, returns are less.
- Like ordinary shares, debenture holders will not be regarded as owners of the company and have no voting rights.
Debentures differ on the basis on terms and conditions on which they are issued.
- Secured/Mortgage Debentures: Debentures secured against assets of the company .i.e. if the company is winding up, assets will be sold and debenture holders will be paid back. The charge/mortgage may be fixed or a floating charge. If it is fixed, charge is on a specific asset say plant, machinery etc. If it is floating charge, it means it is on general assets of the company.
- Which assets are charged: The ones available with the company presently and also assets in future
- Mortgage deed: Includes nature/value of the security, date of interest payment, and rate of interest, repayment terms, and rights of the debenture holders if the company defaults. In the event of default of company to pay interest or principal installment, they can recover their money via the assets mortgaged.
- Unsecured/Naked Debentures: Debentures not secured against assets of the company .i.e. if the company is winding up, assets will be not be sold in order to pay the debenture holders. In other words, no charge is created on the assets of the company which means that there is no security of interest and principal payment. The creditworthiness and soundness of the company serves as a security.
- Redeemable Debentures: Debentures which have to be repaid within a certain specified period. Eg: 5% 2 years Rs. 1000 debenture means redeemable period is 2 years(5%:interest/coupon payment). After redemption, they can be reissued.
- Irredeemable/Perpetual Debentures: These can be paid back at any time during the life of the company .i.e. there is no specified period for redemption. Hence they are also called Perpetual Debentures. Nonetheless if the company has to wind up, then they have to repay the debenture holders.
- Registered Debentures: As the name suggested, these are debentures that are registered with the company. It records all details of debenture holdings such as name, address, particulars of holding etc. Interest shall be paid only to the registered holder (treated as a non-negotiable instrument). They can be transferred by a transfer deed.
- Bearer Debentures: These can be transferred by mere delivery. Company does not hold records for the debenture holder. Interest will be paid to the one who displays the interest coupon attached to the debenture.
- Zero Coupon Debentures: Does not have a specified interest rate, thereby to compensate, they are issued at a substantial discount. Interest: Difference in face value and issue price.
- Specific Coupon rate Debentures: Debentures are normally issued with an interest rate which is nothing but the coupon rate. It can be fixed or floating. Floating is associated with the bank rates.
- Convertible Debentures (Fully/ Partly convertible): Debentures which can be converted to either equity shares or preference shares by the company or debenture holders at a specified rate after a certain period. A company can also issue Partly Convertible Debentures whereby only a part of the amount can be converted to equity/preference shares.
- Non Convertible Debentures (NCDs): These can’t be converted into equity/preference shares.
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