Debentures Explained: Types, Benefits And How To Invest Wisely

Introduction

Ever wondered how the big corporations raise tons of cash and remain independent? The answer lies in debentures—an age-old financial instrument where companies borrow from both big and small investors. In return, investors earn a fixed return on their investment over a specified period.

Whether you are a seasoned investor or just starting, understanding debentures' meaning and how they work can open up exciting investment opportunities. We will traverse through this section towards understanding some of these important facts that distinguish debentures from other instruments, other forms of debentures, and ways to make an informed and wise investment decision in them.

What Is Debenture Investment?

In simple terms, debenture represents an instrument of debt, which companies resort to in order to raise capital from the general public. This is how it happens: I lend money to a company in a way of debentures. 

In turn, the company commits itself to pay me some interest during the tenure of my investment and return the principal amount upon redemption. In general, companies raise capital for expansion plans, working capital requirements, or for consolidating old debts, among other purposes.

In essence, a debenture is a formal document that outlines three key elements: your invested amount (principal), the rate of interest you'll earn, and when you'll receive your payments.

How Do Debentures Work?

Understanding the issue of debentures involves knowing the key steps:

1. Issuing Process

A. Board Approval: A company's directors convene to authorize debenture issuance, determining key factors like investment amount, returns offered, and maturity timeline.

B. Prospectus Preparation: The company creates a detailed document showcasing its financial standing, planned fund utilization, and specific debenture conditions.

C. Investor Subscription: Interested investors can review the prospectus and choose to participate in the offering.

2. Interest And Principal Payments

A. Regular Interest: Investors enjoy scheduled interest payments, which may be distributed quarterly, twice yearly, or annually.

B. Maturity Repayment: Upon reaching the maturity date, investors receive their initial investment back.

Types Of Debentures

In the world of corporate financing, there are different types of debentures, each offering unique features and benefits:

1. Secured And Unsecured Debentures:

Secured debentures come with a safety net in the form of company assets pledged as collateral. In the event that the company defaults, the assets can be liquidated to repay the investors. Unsecured debentures, on the other hand, do not enjoy this protection and usually have higher interest rates to compensate for higher risk.

2. Convertible And Non-Convertible Debentures:

Convertible debentures are ones that offer the investor an opportunity to switch their investment into shares at some predetermined terms. They are again of two types:

I. Fully convertible: The whole investment converts entirely to equity.

II. Partially convertible: Part of the investment remains as debt, while the remaining converts into equity.

NCDs remain as debt instruments throughout their tenure but often provide higher interest rates to compensate for the lack of equity conversion option.

3. Redeemable And Non-Redeemable Debentures

Redeemable debentures have a fixed maturity date when the company repays the principal amount. They're more common and provide clear investment timelines. Non-redeemable or perpetual debentures have no maturity date but continue paying interest until the company opts to redeem them.

Each type serves different investment needs – whether you're seeking security, higher returns, or potential equity participation

Difference Between Bonds And Debentures

Although both bonds and debentures are debt instruments, they differ in very important aspects. Bonds are usually secured by specific assets while debentures are generally unsecured. Bonds are issued by the government or corporate agencies, while debentures are generally raised only by corporations.

The security structure is another area of difference. In case of default, bondholders do tend to get priority claims on assets, whereas debenture holders tend to occupy a lower place in the hierarchy of creditors. Bonds also carry lower interest rates than debentures, which compensate for their higher risk with better returns.

More typically, bonds have standardized terms and face values, which makes them usually more liquid in the secondary markets. Debentures may have an extra flexibility in their terms and conditions, which allows companies to structure them according to specific needs.

Difference Between Shares And Debentures

While shares may represent ownership in a company, debentures represent debt instruments that allow you to become a creditor. Shareholders are entitled to profits in the form of dividends and capital appreciation, but such returns from these investments are not guaranteed. The debenture holder receives a fixed interest rate, irrespective of how well the company performs.

Powers are in the hands of shareholders, giving them a say in company affairs; debenture holders usually have none. However, debenture holders have priority over the shareholders when the company is liquidated. Besides, the company is obliged to pay debenture interest irrespective of losses, while paying dividends is optional.

Difference Between Loans And Debentures

While both debentures and loans are forms of debt financing for a company, they differ considerably in their structure and accessibility. A loan might generally create a direct personal relationship between the company and the financial institution, while debentures give companies the ability to borrow directly from the public.

Loans are very regulated in their provision and compliances, usually with restrictions such as tight covenants, while debentures may be either secured or unsecured. Terms of loans are usually negotiated privately among the parties involved, which can make them flexible, whereas debentures most often provide standardized conditions outlined in the prospectus.

When compared to debentures, loans are more accessible in terms of attaining ready cash; however, they usually have a higher interest cost. Furthermore, debentures are freely traded in secondary markets, providing liquidity that traditional loans cannot.

Advantages And Disadvantages of Debentures

Key Advantages

1. Fixed Returns: Debentures provide a regular return to the investor through periodic fixed interest payments and are good for investors requiring certain returns. This brings about predictability in financial planning.

2. Lower Risk Profile: Debentures have a lower risk than equity investments since the interest needs to be paid to debenture-holders, regardless of how the company's financial performance is going. Besides, debenture holders are paid, in case of liquidation, at a higher priority than shareholders.

3. Tax Benefits: The interest earned on debentures sometimes enjoys tax exemptions that once again result in attractive effective returns. The interest paid on debentures can also be treated as a business expense.

4. Transferability: Most debentures are easily transferable on the secondary market, and therefore, provide investors with liquidity options when needed.

Key Disadvantages

1. Interest Rate Risk: Fixed interest rates will lose attractiveness as an investor if the market rates increase, which will lead an investor to opportunity costs.

2. Credit Risk: Particularly unsecured debentures expose an investor to default risk if the financial stability of the company declines. However, secured debentures aren't entirely without risk, either.

3. Limited Capital Appreciation: In contrast to stocks, debentures offer no promise of capital appreciation above their face value, which restricts the possibility for profit.

4. No Management Control: Unlike shareholders, debenture holders cannot vote, nor voice any opinion about company management.

Key Risk Factors In Debenture Instruments

When investing in debentures, the following critical risk factors warrant careful consideration. Credit risk occupies the topmost position, since the company's ability to make interest payments or to repay the principal will depend on its financial health. Market risk influences debenture values when interest rates fluctuate in the economy.

Liquidity risk arises when investors are unable to sell their debentures easily in the secondary market. The existence of callable debentures means that the issuer, at some time, has the quality of redeeming them out of hand due to fall in interest rates. Moreover, the interest rate risk erodes real returns during inflation periods.

One needs to carefully check the credit rating of the company, its financial statements, and its position in the market before doing so, in order to avoid these risks as much as possible.

Conclusion

Debentures serve as valuable instruments for steady income generation, but they require careful evaluation of your investment goals and risk tolerance. While they offer predictable returns and potential tax benefits, understanding the issue of debentures, features of debentures, is crucial for successful investing.

Beyond debentures, alternative investments like securitised products, fractionalised real estate, and startup equity present numerous opportunities to construct a resilient and diverse portfolio.

Explore  Grip Invest for a thoughtfully curated range of corporate bonds and securitised products. Each option is rated, listed, and regulated, providing a means to combat inflation, withstand volatility, and diversify your portfolio.

Frequently Asked Questions On Debentures

1. What are the risks associated with debentures?

Several risks are associated with debentures, such as credit, interest rate, liquidity, regulatory risks, etc. For example, unsecured debentures have a higher credit risk than secured ones. 

2. Should you invest in debentures or bonds?

Balancing risk and reward delicately is essential when deciding between bonds and debentures. Government and credit-rated corporate bonds offer security, ensuring predictable income and lower risk, albeit with modest returns. Conversely, debentures, especially high-yield options, present the potential for significantly higher returns but carry an increased risk.

3. Are debentures traded like stocks and bonds?

Some debentures, particularly those issued by larger companies and government-backed issues, are actively traded on NSE and BSE. It allows investors to buy and sell before maturity, providing flexibility and potential for profit or loss based on market movements. 

4. How safe is it to invest in debentures?

Debenture risk is dependent on creditworthiness. Debentures from companies carry a higher risk than those issued by governments. Investors must assess the issuer's credit rating and overall financial state prior to investing.

5. Is a debenture a type of loan?

Yes, debenture essentially means a type of loan. These debt instruments enable issuers to borrow funds from investors with the promise of repaying both principal and interest.

6. Is a debenture superior to a share?

Debentures and shares mean different things. Debentures offer fixed interest income, thus a lower level of risk. Shares, on the other hand, offer ownership and therefore a prospect for much higher returns than debentures, but there is so much more risk involved. 

Want to stay at the top of your finances? 

Join the community of 4 lakh+ investors and learn more about Grip Invest, the latest financial knick-knacks, and shenanigans in the world of investing.

Happy Investing!

Disclaimer - Investments in debt securities/municipal debt securities/securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully. The investor is requested to take into consideration all the risk factors before the commencement of trading.
This communication is prepared by Grip Broking Private Limited (bearing SEBI Registration No. INZ000312836 and NSE ID 90319) and/or its affiliate/ group company(ies) (together referred to as “Grip”) and the contents of this disclaimer are applicable to this document and any and all written or oral communication(s) made by Grip or its directors, employees, associates, representatives and agents. This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip does not guarantee or assure any return on investments and accepts no liability for consequences of any actions taken based on the information provided. For more details, please visit www.gripinvest.in

Registered Address - 106, II F, New Asiatic Building, H Block, Connaught Place, New Delhi 110001