Understanding Debentures
When a company decides to raise debt from the public it issues debentures. A debenture is a document issued under the seal of the company having its nominal value. It has the date of redemption, rate and mode of interest payment. A debenture holder is the creditor of the company.
Difference between a bond and a debenture: Bonds are always secured by assets of the company and debentures may or may not be secured by assets. However, in Indian context they are used interchangeably.
Issuance of debentures
The company willing to raise capital through debentures would first issue a prospectus having all the details about the company and the debentures to be issued. There after applications are invited and allotment letters issued. In case applications are rejected, application money is refunded to the investor and in partial allotment, excess application money would be adjusted towards subsequent calls OR remaining amount is refunded.
Debentures can be issued for the following purposes:
- Debentures issued for cash: To raise cash for meeting the expenses of the company.
- Debentures issued for consideration other than cash: payment is done in debentures rather than cash to purchase assets from the vendors.
- Debentures issued as collateral security: Collateral security is the secondary security given in addition to the principal security for availing loans from banks/ FIs. In some cases companies provide debentures as collateral security and don’t pay any interest on them as it has to pay interest on the loan. The lenders can claim there right over debentures only when company couldn’t pay the loan amount and the principal security is insufficient to repay the loan. Otherwise the debentures would be returned to the company.
Classification of debentures
Secured or Mortgage debentures: These debentures are secured by a charge on the assets of the company. In case the company couldn’t pay the principal and interest then the same can be recovered by liquidation of the assets provided as security. These debentures can be first mortgage debentures, second mortgage debentures or unsecured debentures - where the holders have either the first claim, the second claim or no claim whatsoever on the assets charged respectively.
Redeemable debentures: The principal amount of such debentures is paid off to the holders on the expiry as these are issued for a fixed period.
Non-redeemable debentures: These debentures cannot be redeemed during the life span of the company but are paid back only when the company gets liquidated.
Convertible debentures: The debenture holders have the option of converting these debentures into equity shares of the company on the expiry. The terms and condition of conversion are generally specified at the time of issuance of debentures.
Non-convertible debentures: These debenture holders do not have the option of conversion of their debentures into shares of the company.
On the basis of priority the debentures can be classified into “first debentures” and “second debentures” where these debentures are redeemed before other debentures and after the redemption of first debentures respectively.
Debenture is a medium to long term debt instrument which a company issues to raise capital. Investing in debentures can be a safer option than Equity shares because debentures holders are entitled to receive fixed income. The company is obliged to pay the debenture holders unlike the equity shareholders. Equity shareholders are always given a second preference over debenture holders. Shareholders may or may not receive any dividend, but a company has to pay interest to debenture holders even if it incurs a loss. In case of liquidation (closing) of a company, the debenture holders get the first preference for repayment of capital. Debentures are priced higher compared to Equity shares.
Debentures are secured form of money over a period of time as fixed during issuing it. This may be even thought as a type of fixed deposit. Is there even a interest rate attached to it? It is safe bet as compared to shares because on the verge of liquidation the company is liable to pay to its debunture holders rather than the shareholders.