Any business entities whether it is small or large companies require funds to expand and run smoothly their organisations to other regions/ territory. There are many debt instruments available to fulfil their requirements of working capital funds. Debentures are one of those debt instruments so let us explain what does it means.
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Debenture Meaning and Definition:
“Debentures are the debt instruments through which the business entities or government raise the funds from the public/ investors for their working capital and day to day affairs. The Public and Private Ltd companies or the Government issue debentures to raise capital with a promise of repayment at a fixed rate of interest payable periodically.”
In other words, Debentures are a source of working capital finance for a medium and large type of organisations and also from the investor’s point of view. it is an investment opportunity at a fixed rate of interest payable on regular interval like MIS (Monthly Interest Scheme). Also, the interest payable is known as Coupon Rate.
Debentures are an unsecured, short and medium-term source of finance typically not backed by any collateral, however, sometimes other types of debentures are secured and issued against the charge of the company’s fixed assets.
It is issued for the period of a min 1 year to up to 10 years. The Debenture holders are those who hold/ purchase the debentures and get a certificate called debenture certificate. The debenture holders become the creditors of the company.
The debenture trustee is appointed for the sake of debenture holders. Debenture trustee is a caretaker of the investors in case of any default in paying coupon rate as well as at the time of repayment of principal amount by the issuer.
According to investors or lender’s perspective debentures are the most secure types of investments and offer a higher rate of interest as compared to Fixed Deposits.
The issuer has to pay the interest periodically (Half Yearly or Yearly) as per Indenture at the time of issuance. An indenture is a deed/ contract between debenture holders and the issuing company like bonds.
The coupon payment is compulsory before the dividend to shareholders irrespective of market conditions even if the company is in the loss.
The majority of debentures are listed in the stock exchange and also rated by some or the other credit rating agencies. According to their Credit Rating, an investor can judge the creditworthiness and risk associated with the companies issuing debentures.
Advantages of Debentures:
The debentures laid down the numerous benefits from the perspective of both investors as well as issuers. Let us explore each one from both points of view.
Issuer’s Perspective:
- The business entities who issue the debenture don’t require to dilute their ownership to raise funds, unlike equity shares.
- Being an unsecured debt, the company don’t need to arrange collateral unlike other business loans before issuing debentures.
- The Interest payable to debenture holders on periodically (half-yearly or annually) and the principal amount is payable at the specific maturity date. Thus no instant burden to pay the interest and principal amount unlike other forms of business loans.
- The interest payable to creditors is an expenditure to the company which is beneficial to the issuer when it comes to tax benefits.
- The debentures become preferred choice of corporates during inflationary conditions as the interest rates of other forms of loans become higher. Hence it is a cheaper option of medium and long term capital finances.
Read Also, Difference Between Debentures and Bonds | 7 Key Differences
Investor’s Perspective:
- The major benefit to investing in debentures is that It offers a fixed rate of interest (coupon rate) irrespective of market scenarios or even a situation of loss.
- The coupon rate (interest payable) is higher than fixed deposits and payable half-yearly or annually unlike FDs. Some companies offer interest payable on a monthly basis as well.
- Since the majority of debentures are also listed in stock exchange hence tradable and investors can cash out any time in case of a cash crunch.
- All debentures are rated by the credit rating agencies, therefore an investor can choose the best and trustworthy investment opportunity very easily.
- The convertible debentures can also be converted to the equity shares after a certain period of time as mentioned by the issuer at the time of issuance.
Disadvantages of Debentures:
Issuer’s Perspective:
- The issuer has to pay the coupon payment in any circumstances whether the company makes profit or loss unlike shareholders of the company are not paid a dividend in case of loss.
- As it is rated by the credit rating agencies, therefore, it becomes hard to raise funds through debentures for the poor rating companies.
- At the redemption/ repayment date of debentures, the company has to repay the debt, this causes a huge and sudden cash outflow to the company. This might leads to a severe cash crunch in the company.
Investor’s Perspective:
- Debenture holders don’t have voting rights in the company’s annual general meetings as they are creditors of the company not the owner of the company.
- Since it is an unsecured debt instrument, hence in case of bankruptcy of company the recovery becomes a hard nut to crack even in case of secured debentures.
Final Words:
Hope you would have got the pros and cons of the debentures. There are various types of debenture is issued according to the requirement of the different companies. You need to go through all types of debentures to understand the feature of debenture more clearly.
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References: Investopedia
