What is a Debenture?

A Debenture is a debt instrument that is not backed by any collateral and is usually issued for a period of more than ten years. Treasury bonds and Treasury bills are examples of government-issued Debentures. In simple words, a debenture is an unsecured bond that is not backed by any collateral.

Because the government can repay the amount owed by issuing new money, these are considered risk-free. Debentures issued by corporations are generally utilized for long-term loans with a fixed date for repayment as well as a specified interest rate. Hence, they are typically long-term debt instruments used by companies to raise capital.

A debenture is a type of debt instrument that is typically used by large organizations to raise capital at a . Debentures are issued by the organization and are backed by its full faith and credit. It’s a form of unsecured debt with an expiration date generally longer than ten years.

Governments and corporations issue debentures to finance long-term projects such as infrastructure development. Debenture holders are paid periodic interest payments, called coupons, and are repaid the principal amount at maturity.

Understanding Debentures

Debentures, like most bonds, pay periodic interest payments known as coupon payments. Debentures are recorded in an indenture, which is a legal and binding agreement between bond issuers and bondholders.

A debt offering’s terms, such as the maturity date, interest or coupon payments, method of interest calculation, and other characteristics, are all specified in the contract. Debentures are a type of debt that can be issued by both corporations and governments.

Long-term bonds, sometimes known as permanent bonds or perpetual securities, are debt issued by governments. Longer-term government bonds, which have maturities of more than ten years, are often referred to as low-risk investments. The government issuer’s promise is behind these low-risk investments.

Corporations frequently use debentures as long-term loans. The debentures of corporations, on the other hand, are unsecured. Rather than having the financial viability and creditworthiness of the underlying firm’s guarantee, they have only the company’s financial viability and creditworthiness as a backup.

When you’re in debt, it makes sense to take advantage of the interest rates offered. Most of these debts come with an interest rate and are either redeemable or payable on a certain date. Before paying stock dividends to investors, a firm generally makes these predetermined debt interest payments. Because debentures have lower interest rates and longer payback periods than other forms of loans and debt instruments, they are advantageous for businesses.

Types of Debenture

1. Convertible Debentures

Convertible debentures are those that can be converted into equity shares of the company at the Debenture holder’s option.

2. Non-Convertible Debentures (NCD)

Non-convertible debentures are those that cannot be converted into equity shares of the company and must be held till maturity.

Convertible Debentures vs Nonconvertible Debentures

Some of the differences between these on different grounds are

1. Yield to Maturity

The YTM of a convertible debenture is generally lower than that of a non-convertible debenture because the former can be converted into equity shares at the Debenture holder’s option.

2. Tenure

The tenure of a convertible debenture is usually shorter than that of a non-convertible debenture because the former can be converted into equity shares at the Debenture holder’s option.

3. Volatility

The price of a convertible debenture is more volatile than that of a non-convertible debenture because the former can be converted into equity shares at the Debenture holder’s option.

4. Listed or Non-listed

Convertible debentures are mostly listed on stock exchanges, while non-convertible debentures are mostly unlisted.

Features of Debentures – Factors to consider while Buying Debentures

1. Credit Rating

It is important to check the credit rating of the Debenture before investing. The credit ratings are the assessment of the Debenture issuer’s ability to repay the Debenture amount on time.

2. Interest Rate

The market interest rate offered on Debentures is one of the most important factors to consider while investing in Debentures. The higher the interest rate, the higher will be the income from Debentures.

3. Tenure

The tenure of Debentures is another important factor to consider while investing. The longer the tenure, the more will be the time available for repayment of Debentures.

4. Listing

It is important to check whether the Debentures are listed on stock exchanges or not. Listed Debentures are easier to sell as they can be sold on stock exchanges.

5. Convertibility

Debentures can be either convertible or non-convertible. Convertible Debentures can be converted into equity shares of the company at the Debenture holder’s option, while Non-convertible Debentures cannot be converted into equity shares of the company and must be held till maturity.

6. Coupon Rate

The coupon rate is the interest rate at which Debentures are issued. The coupon rate is fixed for the life of the Debenture.

7. Issuer’s Credibility

It is important to check the issuer’s credibility before investing in Debentures. The issuer’s credibility can be checked by looking at the company’s financial statements, credit rating, and past track record.

8. Debenture Redemption Reserve

It is important to check whether the Debenture issuer has created a Debenture Redemption Reserve before investing. The Debenture Redemption Reserve is a reserve created by the Debenture issuer to repay the Debentures on maturity.

9. Exit Option

It is important to check whether there is an exit option available for Debentures. The exit option is the option to sell the Debentures before maturity.

How does a debenture work?

Debentures are issued by companies to raise funds for their business activities.

The Debenture holder lends money to the company and in return, the company agrees to pay interest on the Debenture amount.

The Debenture holder is also entitled to a share in the company’s assets if the company is wound up. Debentures are mostly issued for a period of 5 to 10 years.

Pros and Cons of a Debenture

Debentures have both advantages and disadvantages for the Debenture holder as well as the Debenture issuer.

Advantages of Debentures for Debenture Holders

1. Debentures offer a fixed income to the Debenture holder.
2. Debentures are issued at a fixed interest rate, which makes them ideal for investors who want a stable income.
3. Debentures have a longer tenure than other debt instruments, which gives the Debenture holder time to plan for repayment.
4. Debentures are less risky than equity shares, as they are secured by the assets of the company.
5. Debentures can be converted into equity shares at the Debenture holder’s option, which gives the Debenture holder the potential to earn a higher return on investment.

Disadvantages of Debentures for Debenture Holders

1. Debentures are unsecured, which means that the Debenture holder is not guaranteed payment if the company goes bankrupt.
2. Debentures have a fixed interest rate, which means that the Debenture holder will not benefit from any increase in the company’s profits.
3. Debentures have a longer tenure than other debt instruments, which means that the Debenture holder may not be able to get his/her money back if he/she needs it urgently.

Advantages of Debentures for Debenture Issuers

1. Debentures provide a source of long-term financing for the company.
2. Debentures are less risky than equity shares, as they are secured by the assets of the company.
3. Debentures have a fixed interest rate, which makes them attractive to investors.
4. Debentures have a longer tenure than other debt instruments, which gives the company time to repay the Debenture amount.

Disadvantages of Debentures for Debenture Issuers

1. Debentures have a fixed interest rate, which means that the company will not benefit from any increase in its profits.
2. Debentures have a longer tenure than other debt instruments, which means that the company may not be able to get its money back if it needs it urgently.
3. Debentures are unsecured, which means that the Debenture issuer is not guaranteed payment if the company goes bankrupt.
4. Debentures are secured by the assets of the company, which means that the Debenture issuer may not be able to use the assets for other purposes.

Debenture Examples

U.S. Treasury bond is an example of a Debenture. Debentures are issued by the government to raise capital for various purposes. The Debentures are backed by the full faith and credit of the U.S. government, which makes them one of the safest investments. Debentures are also known as Treasury bonds.

Some other examples of debentures are

1. Corporate Debentures

These are Debentures issued by companies to raise capital. The Debentures are secured by the assets of the company.

2. Municipal Debentures

These are Debentures issued by municipalities to raise capital for various purposes. The Debentures are usually backed by the full faith and credit of the municipality.

3. Housing Debentures

These are Debentures issued by housing finance companies to raise capital for housing projects. The Debentures are usually backed by the full faith and credit of the housing finance company.

4. Student Loan Debentures

These are Debentures issued by student loan companies to raise capital for student loans. The Debentures are usually backed by the full faith and credit of the student loan company.

5. Equipment Debentures

These are Debentures issued by equipment finance companies to raise capital for equipment financing. The Debentures are usually secured by the equipment financed.

6. Mortgage Debentures

These are Debentures issued by mortgage companies to raise capital for mortgages. The Debentures are usually backed by the full faith and credit of the mortgage company.

Debentures vs Bond

Let us understand the difference between these two on different grounds are-

1. Meaning

It is defined as the certificate of indebtedness of a company that is not secured by a mortgage or any other specific charge on assets but only by the general creditworthiness and reputation of the issuer. On the other hand, a bond is an instrument of debt issued by the government and public sector undertakings to raise funds from the market.

2. Nature

Debentures are loans raised by private companies while bonds are raised by public entities.

3. The risk involved

Debentures are unsecured loans which means they rank after all secured creditors in case of liquidation of a company i.e., a higher risk is involved. Bonds are, however, secured loans and hence rank after only preference shareholders.

4. Mortgage

Mortgage Debentures are Debentures where assets of the company are charged as security while bonds are not backed by any asset of the issuer.

5. Charge on Assets

In the case of Debentures, no charge is created on the assets of the company. Bonds lead to the creation of a charge on the assets.

6. Rate of Interest

The rate of interest on Debentures is fixed while that on bonds is variable. It changes with market conditions.

7. Period/ Tenure

Tenure for Debentures is generally longer than that for bonds. Debentures have a tenure ranging from 5 to 20 years while bonds have a tenure of 1 to 10 years.

8. Listing

Debentures are not listed on Stock Exchanges while bonds are listed and traded.

9. Convertibility

Debentures can be both convertible and non-convertible while a bond will always be a non-convertible bond.

Debenture vs Stock

Now that we know the Debenture definition, let us compare Debentures with stocks on different grounds-

1. Risk

The risk involved in Debentures is lower than that in stocks as Debentures are backed by assets of the company. Stocks, on the other hand, are not backed by any asset and hence are riskier.

2. Tenure

The tenure for Debentures is generally longer than that for stocks. Debentures have a tenure ranging from 5 to 20 years while stocks do not have a fixed tenure. They can be traded at any time.

3. Interest Payment

Interest on Debentures is paid periodically while dividends on stocks are paid only when declared by the Board of Directors.

4. Taxation

Interest on Debentures is taxable while dividends on stocks are tax-free.

Convertibility

Debentures can be both convertible and non-convertible while stocks are always non-convertible.

Conclusion!

In the end, we may describe debentures as a form of bond that a government or business can utilize to raise money.

Those who invest in debentures lend the entity money and receive it back with interest, just like other bonds. A debenture is an unsecured debt instrument.

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