Among various debt instruments, debentures are one class of instruments that do not get secured by collateral. They have more than 10 years of the term. The issuer’s reputation and creditworthiness are taken into consideration when debentures are issued at a fixed rate of interest. By means of debenture, the government and the companies issue loans. It can be termed as the IOU bond between the purchaser and the issuer. Companies, when in need of an extension, borrow money at a fixed interest rate and thus, use debenture for the expansion purpose.
Definition and Purpose of Debenture
As per corporate finance, a medium-to-long-term debt can be termed as debentures which are used by the government and large companies for borrowing money and investing with a fixed interest rate. A debenture, in legal terms, can be referred to as certificates of loan or a loan bond which have the evidence of the fact that the company borrowing debentures has the liability to pay a particular amount of money along with interest after a specified time. The money the company raises by putting the debentures to use becomes a part of the capital structure of the company. But, it does not still get to be the share capital.
Debentures are movable property which is issued by a company in the form of indebtedness and/or a certificate. The debentures may or may not have a charge on the company assets. The debenture holders are the creditors of the company borrowing the money. But, the debenture holders are not considered to be the shareholders of that very company.
Types of Debentures
In layman’s terms, the debentures can be of four types. Each type is described in the following section in an elaborate way.
1. Secured and Unsecured Debentures
Secured debentures are bonds that come with collateral issued. The party that issues the bond offers assets or other property which can be taken possession of in case of failure of the debt repayment by the issuer.
Unsecured debentures, on the other hand, do not have collateral security with it. No asset or property is allotted for such debentures. The creditworthiness of the issuer is all that is taken into consideration here.
2. Registered and Bearer
Companies have their own register of debenture holders. Those debentures which are recorded in these registers are referred to as registered ones. But those which can be transferred by the simple delivery method are termed as bearer debenture.
3. Convertible and Non-convertible
Those debentures which can be converted, i.e. turned into equity shares, can be termed as convertible debentures. This conversion is possible only after a specific time period is over. Debentures, which cannot be converted into equity shares are marked as non-convertible debentures.
4. First and Second
Not all debentures are paid at the same time. Debentures which are paid before other similar debentures are known as first debentures. These have the first charge over the company assets. Second debentures are those the repayment of which follows that of first debentures.
Advantages of Debentures
If investors have their eyes fixed upon incomes with fewer risks associated, debentures are the appropriate thing. There are no voting rights involved with debentures. Thus the control of equity shareholders on the management is not diluted. Another advantage of debentures is that it is less costly an affair to finance via them compared to the equity capital. This is because the interest on debentures is compatible with the tax deduction.
The company which takes the loan in the form of debenture does not have to make the profits a part of it. Thus it is advantageous for the companies also. Even when the sales and earnings are relatively stable, the debentures can be put to use without any worries.
Disadvantages of Debentures
Once a debenture is issued, the borrowing capacity is automatically reduced. Also, even if the company is facing financial strains, it has to repay the debts on the specified date. This is especially true with redeemable debentures.
Moreover, the earning of a company is permanently burdened with the issue of the debenture. So, if the earning fluctuates, the risk becomes greater too.
So, debenture, in a nutshell, is a loan capital of a particular company. It is up to the demand of the company or government what type of debenture they would choose to fulfil their purpose. The main reason for issuing a debenture is raising the capital funds. Corporation or government, both should verify the demerits well before issuing a debenture to avoid undesirable consequences in future.
