What is a Debenture? Types, Merits and Demerits

Understanding Debenture 

 

A debenture is a financial instrument of debt with or without any collateral security that is borrowed to an entity on the basis of its credibility or reputation. Characterized by a fixed rate of interest, a debenture is a long-term monetary instrument that lasts up to 10 years or even more than that. One who credits money to the issuing entity of a debenture is known as a debenture holder or credit holder. 

 

Usually, a debenture is issued to investors that lend financial support to governments or organizations that are trustworthy and reputed. It should also be noted that the interest procured on debentures is fully taxable. 

 

All debentures are loans, but not all loans are debentures. The importance of debentures is immense as it is not only a source of investment but also a secure means of earning money on regular intervals. 

 

Due to key differences that exist between debentures, loans, and bonds, these financial instruments are all distinct concepts. Originating from the Latin word “debentur”, the term debenture means ‘there are due’. 

 

(Related blog: What are RBI bonds?)

 

A financial instrument that defines borrowing of money usually without any collateral security, debenture can be understood in the light of Treasury Bills issued by the Government of India to investors at zero rate of interest. 

 

These are short-term monetary instruments that are issued at a discount rate and redeemed at the face value (INR 100) at the time of maturity. Here is an excerpt from RBI-  

 

“For example, a 91 day Treasury bill of ₹100/- (face value) may be issued at say ₹ 98.20, that is, at a discount of say, ₹1.80 and would be redeemed at the face value of ₹100/-.

 

Types of Debenture 

 

Based on the different types of debentures, the characteristics of this instrument can be determined. However, they may differ from type to type, and thus, the features change. Let us now discover the most common types of debentures and get started with their respective features. 

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Types of Debentures

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1. On the Basis of Maturity

 

• Redeemable Debenture- Based on the time period of a debenture, a redeemable debenture carries an end date on which the investor can redeem the money invested in the debenture. For instance, a redeemable debenture that has a maturity date of  5 years will release the principal amount along with the rate of interest accumulated on the amount at the end of 5 years from the date of issue. 

 

• Irredeemable Debenture- Based on the tenure of a debenture, an irredeemable debenture is a debenture that carries no date of maturity and can be only redeemed when a company or an organization’s existence comes to an end or a long time passes by. 

 

 

2. On the basis of Security

 

• Secured Debenture- When it comes to the aspect of security, a secured debenture is backed by collateral that is presented to the investor at the time of issuing the debenture. For instance, when a company issues a secure debenture, it provides its assets or a definite span of property in case it fails to repay the borrowed money to the investors. 

 

• Unsecured Debenture- Unsecured debentures do not present collateral that can assure the investors that their money will be repaid or reimbursed when the time comes. Instead, such a debenture is purchased solely on the basis of the issuing authority’s credibility, past reputation, and growth in its performance so far. Unsecured debentures are also termed Perpetual Debentures. Furthermore, it can also be determined if the investor wishes to receive a lump sum amount altogether or partial payments at regular intervals.

 

 

3. On the basis of Rate of Interest 

 

• Fixed-rate Debenture- Another type of debenture on the basis of the rate of interest is fixed-rate debenture. Such a debenture has a fixed rate of interest that implies that the principal amount will be added along with the interest procured from the debenture and will be released at the time of maturity. This debenture’s rate of interest does not change, it stays fixed. 

 

• Floating-rate Debenture- A floating-rate debenture has a rate of interest that keeps changing or is revised at regular intervals. This revision is done by the issuing authority (for instance, a government or an organization) at regular intervals. 

 

The revised rates of interest are specified on coupon rate that define the rate of interest for a particular debenture.

 

(Also read- Types of Financial Bonds) 

 

Therefore, on the basis of security, maturity, and interest rate, debentures can be classified into the above-mentioned types. 

 

 

How does a Debenture work? 

 

Like bonds, debentures are also released by particular companies or governments when they are in need of financial assistance or debt capital . When organizations tend to undertake some major developmental projects, they issue debentures to investors that can be either secured or unsecured. 

 

Intended for the purpose of raising capital, debentures act as a source of investment for those looking to invest their money in secure places. However, unsecured debentures are often high-risk investments that attract high rates of interest in order to make investors lend money. 

 

(Must check: Capital in Economics)

 

Generally issued with a long duration, debentures may last up to 10 years or even more depending on the financial operations undertaken by the issuing authority. If the debenture is redeemable, the borrowed money is required to be repaid at the expiry of the debenture. 

 

However, if an irredeemable debenture is issued, the principal amount along with the rate of interest is not liable to be paid at a certain date. Rather, the amount could be paid when the organization itself ceases to exist or when a long time passes by. 

 

Since debentures are mostly long-term debt instruments, the investors seek security in order to stay assured that their money will be repaid. Yet unsecured debentures carry higher rates of interest that also benefit the investors. 

 

(Similar blog: What is a mortgage?)

 

The structuring of a debenture defines the necessities that are required to be fulfilled. Let us now have a look at the way debentures are structured. 

 

• A trust indenture is a first and foremost necessity that is required to be done away with. This is a draft agreement that takes place between the issuing authority and the investing entity of the debenture. 

• The second step is that of issuing the coupon rate. The coupon rate consists of the specified interest rate that can be either fixed or floating in nature. 

• The third step is to specify if the debentures are convertible or not. This means that debentures can either be non convertible debentures (they can only be redeemed in the form of money) or can be convertible (they can be converted into equity shares of the issuing authority).  

 

(Referred blog: Mutual Funds in India)

 

 

Merits and Demerits of Debenture 

 

In this segment, we will understand the various merits and demerits of debenture that will be helpful for us to understand the concept in a better manner. 

 

Merits

 

1. Definite Maturity Period

 

Debentures are primarily advantageous because of their definite maturity period. In the case of redeemable debentures, one can redeem the amount at the time of maturity. 

 

Unlike other fiscal instruments, a debenture has a fixed time period and thus assures the investor that the money will be repaid. 

 

2. Static Rate of Interest

 

One of the advantages of debentures is that they have a static rate of interest. This means that even when companies are recording low profits and their economic condition is stooping low, they are required to pay the determined rate of interest. 

 

Unlike floating rates of interest, fixed-rate debentures allow investors to stay worry-free. 

 

3. Secure Investment

 

Be it a secured debenture or unsecured debentures, an investor has a source of secure investment in the form of a debenture. How? Well, in the case of secure debentures, the investors have the surety of collateral (company assets or shares) and thus have their money invested in a secure place. 

 

On the other hand, unsecured debentures also require the issuing authority to release promissory to respective investors mentioning that their money will be repaid on time. 

 

In case a company fails to perform well in the long run then the debenture holders are paid first and equity holders are left with nothing. This is one of the biggest advantages of debentures. 

 

(Recommended blog: What is a Credit Rating) 

 

Demerits

 

1. No hold over ownership

 

While equity shareholders are liable to have control in the operations of the issuing entity, debenture holders have no hold over the ownership and thus, have no voting rights to direct the company’s affairs towards their interest. 

 

This is one of the numerous demerits of debentures. 

 

 

2. Taxable Interest Rate

 

Another one from the list of disadvantages of debentures is that these have a taxable rate of interest. 

 

This implies that whatever interest is procured on the principal amount of the debenture, is fully taxable and hence, investors can lose their money to taxes while shareholders can avoid taxes. 

 

 

3. Static Rate of Interest

 

While a static rate of interest or a fixed interest rate is one of the advantages of debentures, it is simultaneously one of the biggest demerits too. 

 

This is because in case the company is performing exceedingly well, a fixed rate of interest implies that the creditors will only receive the interest rate that was determined a long time ago and thus, will have no share in the profits incurred in recent times. 

 

 

Summing Up 

 

To sum up, debentures are debt instruments that are issued with or without collateral. A rather long-term investment, debentures usually extend up to 10 years or more depending on the draft agreement. 

 

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On the basis of security, maturity, and interest rate, debentures can be classified into redeemable debentures and irredeemable debentures, secured and unsecured debentures, and fixed-rate debentures and floating-rate debentures respectively. 

 

An advantageous source of investment, debentures are different from loans and corporate bonds or government bonds yet are popular in the field of investment. Issued in order to raise capital for financial projects or other fiscal purposes, debentures are fairly easy to understand and are profitable for long-term investments too when one is looking to sustain personal finance. 

 

(Also read- Mutual Funds for investment)