A debenture is a type of bond that is used by large companies to borrow money at a fixed rate of interest. The legal term "debenture" originally referred to a document that either creates a debt or acknowledges it, but in some countries, the term is now used with bonds, loans, or stock. Whenever a bond is unsecured it can be termed as a debenture.
In this case, investors still invest in these bonds as they have faith in the issuer. Large companies with humongous capital and a positive cash flow along with excellent credit ratings can usually offer debentures. Companies having permission from a regulatory body/authority like Ministry or Department of the Central Government, Reserve Bank of India, or the National Housing Bank can issue debentures for a period of more than ten years. Debentures are mainly issued by the government and large companies since it mainly works on the reputation of the issuing authorities
In a sense all debentures are bonds but all bonds are not debentures.
To understand this let us understand the features which make bonds and debentures different
Description | Bonds | Debentures |
Collateral | Bond is secured by some collateral | Debentures on the other hand might be secured or unsecured. In most cases, debentures are unsecured since they are issued by large reputed companies and governments where investors are willing to invest in them seeing their reputation in the market. |
Tenure | Bonds can be considered as a long-term investment having a long-term tenor | Since the debentures are issued for a specific purpose the tenor is comparatively short term. Eg: a debenture can be issued by a company having a cash crunch or a company can issue a debenture to expand its business with a new project. |
Issuer | An issuer of a bond is mostly a financial institution, government agency, large corporation. | Debentures are issued by private companies in almost all cases |
Level of risk | Bonds are considered safe since having the feature of being collateral by something | Debentures on the other hand are a little riskier since they are not backed by any kind of collateral. Instead, they are based on the faith and credit of the issuer. |
Rate of Interest | Bonds generally offer a low rate of interest since the sustainability and stability of repayment is high | Debenture Offers a higher rate of interest as they are unsecured and backed only by the reputation of the issuer. However High yield bonds do offer a higher rate of interest |
Convertible factor | Bonds cannot be converted into equity | Debentures have this facility to convert into shares. However Additional Tier 1 bonds are raised as a part of permanent equity but not converted into equity. |
Priority in case of liquidation | Bonds are repaid first | Debenture holders are paid once the bondholders are repaid |
Type of debentures:
1. Secured Debentures- Secured debentures are issued with collateral. In other words, the lender receives a kind of insurance against the loan not being paid back. If the issuer goes bankrupt or defaults and cannot pay off their debt, the lender can redeem what is owed by acquiring the assets which belong to the borrower. (so a secured debenture is basically a bond)
2. Unsecured Debentures- A debenture is considered unsecured when it is not backed by any collateral. If the company becomes insolvent the lender must immediately claim the asset of the borrower.
3. Redeemable Debentures- Redeemable debenture is a debt that has a specific repayment date. The issuer is bound to repay such loan by a predetermined date to the lender or debenture holder. This clause attracts more investors with a redeemable debenture because investors are more assured of getting repaid.
4. Irredeemable Debentures- Irredeemable debenture is an agreement between two parties which is the lender and the borrower usually with a favorable interest rate. In this case, if the company liquidates the debenture ensures that the lender is on priority to receive their funds. They are also called perpetual debenture because the company does not give any undertaking for the repayment of the money borrowed by issuing such debentures. Such debentures are issued by manufacturing firms or financial institutions
5. Convertible Debentures- Convertible debentures are long-term debt that has an option to convert into equity after a specific period of time.
6. Non-Convertible Debentures- Non-Convertible Debentures do not have an option to convert themselves into equity.
7. Specific Coupon Rate Debentures- Specific Coupon Rate Debentures are issued with a specified rate of interest known as a coupon rate. The coupon rate may be fixed-rate or floating rate. The floating rate is usually linked with the bank rate. The debenture holder will not get any interest in these types of debentures and they are redeemed at face value.
8. Zero-Coupon Rate Debentures- Zero-Coupon Rate Debenture is a debt security that does not pay any interest. These types of debentures trade at deep discounts offering face value profits at maturity. The difference between the purchase price of the zero-coupon debenture and the par value indicated the investor’s profit on investment
9. Registered Debentures- Registered Debentures are debentures that are recorded in the company's debenture-holder register with every single detail of the debenture holder. They are not negotiable. These debentures are only payable to the registered holders which means persons whose name appears in the Register of Debentures. They are transferable in the same way as shares are transferable. This means they can be transferred only by a transfer deed which is a document used to record the transfer of ownership
10. Bearer Debentures- Bearer Debentures are not recorded in the register of a company. They are unregistered debentures and no records are maintained in the companys debenture-holder register for the ownership of these debentures. They are issued physically which means issued on paper. Issuing bearer debentures is easy as no third party or intermediary is needed since these can be simply transferred by just handing over the certificate to the other person. The interest payments on such debentures are physically attached to the security of the bank or the issuing company. These debentures can be redeemed within thirty days from the date of maturity which is printed on the bond
Debentures are exposed to certain risks mentioned below:
Interest rate risk- Debentures have a fixed rate of interest and a fixed repayment of the principal amount if the security is to hold till maturity. The main risk associated with fixed-rated securities is the opportunity cost that a better rate of return may be available elsewhere if interest rates were to increase.
Credit risk- Credit risk is the risk where the issuer is not able to repay the interest and capital amount. A good credit rating by a credit rating agency gives a measure of confidence for investors.
Liquidity risk- The majority of debentures do not offer a readily available exit mechanism and as such should be considered as an illiquid investment.Eg: we may own real estate but due to bad market conditions it can only be sold imminently at a high sale price
Debentures are associated with few benefits along:
Coupon rate- A debenture pays a regular interest rate or coupon rate return to investors.
Convertible- Convertible debentures can be converted to equity shares after a specified period, making them more appealing to investors
Liquidation - In the event of a corporation's bankruptcy, the debenture is paid before common stock shareholders.
Bonds and Debentures have many common features but they are individually two separate debt instruments. Many times people get confused between them and use the terms interchangeably. It is very vital to understand the key difference between them. In the end, the first key step towards any investment is to have in-depth and correct information about the investment.