What is Debenture? Features, Types, Process And Advantages

When it comes to raising money, companies have various options. Starting from the IPO to seeking investors, the choices are many. But all these involve dilution of the stake, which is not always a good idea. This is where seeking debentures can be a great option. 

The debenture meaning is simple. It is a type of loan. Companies get direct funding from the people without the need for any security deposit. The investors or debtors here earn interest on the money they lend.

But that is not it. There is more to it. So, read this guide to know what is debenture and why one should invest in them. 

Understanding Debenture

Understanding what is debenture in accounting is very important. In simple words, a debenture is a type of long-term debt instrument. It is used by companies to raise funds from the public. 

The debenture meaning explains its nature as a loan with no underlying security involved. Though there are a few secured options, this is not common. Investors who buy debentures are called debenture holders. They are not owners in the company but lenders. 

Debentures carry a fixed time period and interest. Upon maturity, the principal amount is paid back. This makes them a safer choice for those looking to get fixed returns. 

Features of Debenture

Debentures have distinct features that make them attractive to companies and investors.

1. Fixed Rate of Return: Debentures offer a fixed interest rate decided at the time of issue, ensuring regular income for holders.

2. No Management Control: Debenture holders are creditors, not owners. They have no voting rights or say in company decisions.

3. Defined Tenure: Debentures are issued for a fixed period, after which the principal amount is repaid to holders as agreed.

4. Priority Claim: In case of liquidation, debenture holders are paid before equity and preference shareholders, reducing their risk.

5. Transferability: Debentures can be traded on stock exchanges, offering liquidity and flexibility to investors.

6. Security Backing: Many debentures are secured against company assets, giving holders extra safety and assurance of repayment.

7. Convertibility: Convertible debentures can be converted into equity shares after a specified time, while non-convertible debentures remain debt instruments till maturity.

8. Redeemable or Irredeemable: Redeemable debentures are repaid on a fixed date. Irredeemable debentures continue until the company winds up.

These features make debentures a structured, stable, and low-risk option for raising funds and for investors seeking assured returns without ownership responsibilities.

Types of Debenture

Debentures come in different types based on security, convertibility, and repayment features. The top types of debentures to know are as follows:

1. Registered Debentures

These are the ones with the holder’s name on them. This means, only the registered holder of the debenture can claim them in the future. Though these can be transferred, there is a proper legal process for the same. This ensures legal ownership and security for both.

2. Bearer Debentures

Bearer debentures are not registered with the company. They are transferable by delivery alone. Whoever holds the physical certificate is considered the owner and can claim interest. This makes them highly liquid and easy to trade in financial markets without any formalities.

3. Secured Debentures

These are also known as the mortgage debentures. These are backed by specific company assets as security. If the company fails to repay, debenture holders can claim the secured assets to recover their money. This reduces risk for investors and gives them assurance of repayment.

4. Unsecured Debentures

These debentures do not have any specific asset backing them. They depend entirely on the company’s reputation and creditworthiness for repayment. Due to the lack of security, they carry higher risk compared to secured debentures and are also known as naked debentures.

5. Redeemable Debentures

Redeemable debentures come with a fixed maturity period. The company repays the principal amount on the maturity date as stated in the agreement. This gives investors certainty regarding repayment and helps companies plan their debt obligations better.

6. Irredeemable Debentures

Also called perpetual debentures, these have no fixed maturity date. They continue as long as the company exists or until it decides to repay them. Investors receive regular interest payments but may not get principal repayment within a set time frame.

7. Convertible Debentures

Convertible debentures can be converted into equity shares after a specified period. This gives investors the benefit of fixed interest income initially and the option to become shareholders later, participating in the company’s growth and profits.

8. Non-Convertible Debentures

These debentures cannot be converted into equity shares. They remain as debt instruments until maturity. Investors receive fixed interest income but do not gain any ownership rights in the company under these types of debentures.

9. First Mortgage Debentures

First mortgage debentures are secured by a first charge on company assets. In case of default, these debenture holders get the first right to claim repayment from the secured assets before any other creditors, giving them strong financial security.

10. Second Mortgage Debentures

These debentures have a second charge on company assets. If the company is liquidated, second mortgage debenture holders are paid only after the first mortgage debenture holders have received their dues, making them relatively riskier.

11. Fully Convertible Debentures

Fully convertible debentures are entirely converted into equity shares of the company after a certain period. Holders then become shareholders, gaining ownership rights, dividends, and voting power, while also benefiting from the company’s growth potential.

12. Partly Convertible Debentures

In partly convertible debentures, a portion is converted into equity shares while the remaining part stays as debt. This gives holders the dual benefit of fixed returns on the debt part and ownership advantages from the converted shareholding part.

The Process for the Issue of Debenture

Debentures are issued by companies under the Companies Act, 2013 to ensure legal compliance and protect investors. Here are the steps:

1. Board Meeting

Approve the issue of debentures, draft the offer letter (Form PAS-4), and appoint a debenture trustee if the issue exceeds 500 persons. Approve raising borrowing limits if needed.

2. Preparation of Documents

Draft the offer letter, Debenture Subscription Agreement, and Debenture Trustee Agreement. Prepare the list of persons to whom the offer will be made.

3. Extraordinary General Meeting (EGM)

If required, call an EGM to pass a special resolution approving the issue and increasing borrowing limits. Approval for creating a charge on assets is also taken here.

4. Filing with Registrar of Companies (ROC)

File Form MGT-14 for the special resolution and submit Forms PAS-4, PAS-3 (return of allotment), and CHG-9 (charge creation) with the Registrar of Companies within stipulated timelines.

5. Offer and Subscription

Issue the offer letter to selected persons (private placement) or the public. Open a separate bank account to receive application money.

6. Allotment and Certificate

Hold a Board Meeting to approve allotment. Issue debenture certificates within six months of allotment.

7. Register of Debenture Holders

Update the Register within seven days of allotment approval, except for dematerialised debentures.

Additional Requirements

Appoint a debenture trustee for issues exceeding 500 persons, create a Debenture Redemption Reserve, and obtain a credit rating for the issue.

What is Debenture Interest

Debenture interest is the fixed return paid by a company to its debenture holders for using their funds. It is a legal obligation and must be paid regularly, even if the company does not make any profit during that period.

• Fixed Rate: The interest rate is fixed at the time of issue. For example, if a company issues debentures at 9%, holders will receive 9% of the face value every year.

• Regular Payment: Interest is paid half-yearly or annually, as stated in the debenture terms.

• Priority over Dividends: Debenture interest is paid before any dividend is given to shareholders because debenture holders are creditors, not owners.

• Tax Treatment: For the company, debenture interest is treated as a business expense and reduces taxable income. For holders, it is taxable as income received.

• Legal Obligation: Companies must pay this interest on time. Non-payment can lead to legal action by debenture holders.

Who are the Debenture Holders

Debenture holders are individuals or institutions who lend money to a company by buying its Redemption of debenture is the repayment of the principal amount to debenture holders when the maturity period ends. It removes the company’s liability and maintains financial discipline. Debentures can be redeemed in three ways:

• At Par: Repayment is equal to the face value. For example, a Rs. 1,000 debenture is repaid at Rs. 1,000.

• At Premium: Repayment is higher than face value. A Rs. 1,000 debenture redeemed at a 5% premium gives Rs. 1,050.

• At Discount: Repayment is lower than face value. A Rs. 1,000 debenture redeemed at Rs. 950. This is rare.

Methods of Redemption of Debenture

Companies use different methods to redeem debentures based on their financial strategy and the agreement with debenture holders. The main methods are:

1. Lump Sum Payment at Maturity

The company repays the entire principal amount on the maturity date in one payment. It is simple but requires strong fund management to ensure timely repayment.

2. Redemption by Instalments

The company repays the debenture amount in parts over its tenure. For example, a Rs. 1,000 debenture can be repaid as Rs. 200 annually for five years, reducing repayment burden.

3. Purchase from Market Before Maturity

Companies may buy back their debentures from the open market before maturity. If market prices are low, this reduces total repayment cost and lowers overall debt.

4. Conversion into Shares

Convertible debentures are redeemed by converting them into equity shares after a specific period, ending debt obligations and turning holders into shareholders.

5. Using Debenture Redemption Reserve (DRR)

Companies maintain a DRR by setting aside part of their profits to ensure funds are available for redemption, securing debenture holders’ interests.

6. Call and Put Options

• Call Option: Allows the company to redeem debentures early at a pre-fixed price to reduce interest costs.

• Put Option: Allows holders to demand early repayment, giving them financial security.

Advantages and Disadvantages of Debentures

Debentures help companies raise funds efficiently and offer investors fixed income. However, they have both benefits and limitations.

Advantages of Debentures

• Fixed Income: Provide regular and predictable interest payments to investors.

• Lower Risk: Priority claim over shareholders in case of liquidation.

• No Ownership Dilution: Debenture holders are creditors with no voting rights.

• Efficient Fundraising: Companies raise large funds without giving away ownership.

• Liquidity: Often listed on stock exchanges for easy buying and selling.

• Tax Benefits: Interest paid is treated as business expense, reducing taxable income.

• Redemption Flexibility: Companies can redeem when surplus funds are available.

• Potential Higher Returns: May offer better returns than savings accounts or FDs.

• Asset-backed Security: Secured debentures offer additional safety to investors.

Disadvantages of Debentures

• No Voting Rights: Investors cannot influence company decisions.

• Obligatory Payments: Companies must pay interest even with low or no profits.

• Asset Encumbrance: Secured debentures require pledging assets, limiting use.

• Fixed Rate Risk: Fixed rates may be less attractive if market rates rise.

• Credit Risk: Unsecured debentures depend on the company's creditworthiness.

• Repayment Obligation: Principal must be repaid at maturity, creating burden.

• Market Risk: Debenture value fluctuates with market interest rates or credit ratings.

Difference Between Shares and Debentures

The table below highlights the key differences between shares and debentures:

Conclusion

Debentures are one of the finest ways to raise funds. The company can get loans at lower rates, and there is no dilution. Investors can earn interest on their money in a safe manner. Both parties can fulfill their needs with no hassle involved. 

But it is important to evaluate the options before moving ahead. This is where Rupeezy offers you a screener and analysis tools. Check the options and make the right investing decisions. This will ensure that your money grows over time.

FAQs 

Q1. What is the main purpose of issuing debentures?

The main purpose of issuing debentures is to raise long-term funds without diluting ownership. Companies use debentures to meet expansion, project, or working capital needs while keeping control with existing shareholders.

Q2. Are debentures better than fixed deposits?

Debentures often offer higher returns than fixed deposits but carry slightly higher risk, especially unsecured ones. Fixed deposits are backed by banks and considered safer, while debenture safety depends on the issuing company’s financial strength.

Q3. Can I sell my debenture before maturity?

Yes, most debentures are listed on stock exchanges and can be sold before maturity. However, the resale value may vary based on market interest rates and the company’s credit rating at the time of sale.

Q4. How is debenture interest taxed for investors?

Debenture interest is treated as income from other sources and is fully taxable as per the investor’s income tax slab. Companies deduct TDS if the interest exceeds the applicable threshold limit.

Q5. What happens if a company fails to pay debenture interest?

If a company fails to pay debenture interest, debenture holders can take legal action to recover their dues. In case of secured debentures, holders can claim the secured assets for repayment.