In this Article, we are going to discuss about Debentures Meaning, Features, Advantages, Disadvantages. Investing in stock Market Notes
Meaning of Debentures
According to Sec. 2 (30) of the companies Act, 2013, debentures include “debenture stock, bonds and any other instruments of a company evidencing a debt, whether constituting a charge on the assets of the company or not.”
Debentures are debt securities issued by a joint stock company. Amounts collected by way of debentures form part of the loan capital of a company and are repayable after a fixed period. Debenture holders get fixed rate of interest on their debentures as a charge against profit. They are creditors of the company.
Bonds, like debentures, is an acknowledgement of debt issued under the common seal of a company. The only difference between bonds and debentures is that rate of interest is not pre-determined in case of bond, but in case of debentures rate of interest is fixed.
Features of Debentures
Specific features of debentures as a source of finance are stated below:
1. Debt Instruments: Debentures are debt instruments which creates a charge on the assets of the company.
2. Interest rate: The interest rate on a debenture is fixed and known which is payable by the company even in case of loss. It indicates the percentage of the face value of the debenture that will be paid out annually or semi-annually or quarterly in the form of interest.
3. Maturity: Debentures are issued for a specific period of time. The maturity of a debenture indicates the length of time until the company redeems (returns) the par value to debenture-holders and terminates the debentures.
4. Redemption: They are normally repayable at the end of a fixed period. Repayment of debenture or cancellation of debenture liability in the books of the company is known as redemption of debentures.
5. Sinking fund: A sinking fund is cash set aside periodical for redeeming debentures. The fund so accumulated is under the control of the trustee who redeems the debentures either by purchasing them in the market or calling them in an acceptable manner. In some cases, the company itself may handle the retirement of debentures using the sinking funds.
6. Security: Debentures may be issued with or without the security of assets of the company. In the event of winding up of the company the debenture holders are treated as creditors and given priority in repayment of their money.
7. No voting rights: Debenture holders are the creditors of a company. They do not have voting right. Debenture holders normally do not have representation in the Board of the company.
8. Listing on stock exchange: They may or may not be listed in the stock exchange.
Advantages of Debentures
1. Less Costly: Cost of debt is less as compared to cost of equity. Also interest paid on debentures is tax deductible.
2. Long Term Source of finance: Debentures provide long term funds to the company without diluting its control.
3. Tax Saving: Interest paid to debenture-holders is a charge on income of the company and is deductible from income for income tax purpose. The post-tax cost of debt is thus lowered.
4. Fixed maturity period: Debentures provide funds to the company for a specific period. Hence, the company can appropriately adjust its financial plan to suit its requirements.
5. Over-capitalisation avoided: Since debentures are generally issued on redeemable basis, the company can avoid over-capitalisation by refunding the debt when the financial needs are no longer felt.
6. Fixed interest Rate: In a period of rising prices, debenture issue is advantageous. The burden of servicing debentures, which entail a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases.
7. Trading on Equity: Debentures enable the company to take advantage of trading on equity and thus pay to the equity shareholders dividend at a rate higher than overall return on investment.
8. Suitable for Conservative Investors: Debentures are suitable to the investors who are cautious and conservative and who particularly prefer a stable rate of return with minimum or no risk.
Disadvantages of Debentures
1. Obligatory Payments: Debenture interest and capital repayment are obligatory payments. Failure to meet these obligations can jeopardize the solvency of the firm.
2. Fixed interest payment as a charge against profit: In the case of debentures, interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. In case of continuous loss, it becomes a great burden on the finances of the company.
3. Increase in Cost of Equity Capital: Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital.
4. Adverse effect in Credit Rating: Debentures are issued as a floating charge on the assets of company. When assets of the company get tagged to the debenture holders the result is that the credit rating of the company in the market comes down and financial institutions and banks may refuse loans to that company.
5. Adverse effect on Dividend: Debentures are particularly not suitable for companies whose earnings fluctuate considerably. In case of such company raising funds through debentures may lead to considerable fluctuations in the rate of dividend payable to the equity shareholders.
Types of Debentures
Types of Debentures: Debentures are classified as follows:
On the Basis of Repayment
a) Redeemable Debentures: These debentures are paid off or redeemed after the prescribed period.
b) Irredeemable or Perpetual Debentures: These debentures are permanent debentures of a company. They are paid back only in the event of winding up of a company.
On the Basis of Transferability
a) Registered Debentures: These are debentures for which the company maintains record of debenture holders.
b) Bearer Debentures: These debentures are transferable by mere delivery. There is no need or registration of transfer with the company.
On the Basis of Security
a) Simple or Naked Debentures: These are debentures not secured by any asset of the company.
b) Mortgage Debentures: Mortgage debentures are issued on the security of certain assets of the company.
On the basis of Conversion
a) Convertible Debentures: These debentures are issued with an option to debenture holders to convert them fully or partly into shares after a fixed period. Where only a part of the debenture amount is convertible into equity shares, such debentures are known as ‘partly convertible debentures’. When full amount of debentures are convertible into equity shares, such debentures are known as ‘fully convertible debentures.’
b) Non-Convertible Debentures: These are debentures issued without conversion option.
On the Basis of Pre-Mature Redemption Rights
a) Debenture with “Call” option: A callable debenture is one in which the issuing company has the option of redeeming the security before the specified redemption date at a pre-determined price.
b) Debenture with “Put” option: This is a debenture in which the holder has the option of getting it redeemed before maturity.
On the Basis of Coupon Rate (interest rate)
a) Fixed Rate Debentures: Most of the time debentures are issued with a prefixed rate interest. These debentures are called fixed interest debentures
b) Floating rate Debentures: Floating rate as the names suggests keeps changing.
Zero Coupon Bonds: These are debentures issued with no interest specified. They are issued at a substantial discount to compensate the investors. These bonds are known as deep discount bonds.