Debenture in Corporate Finance

Introduction to Debenture

Debenture is a type of investment. It is a marketable security that is issued by businesses or organizations which raise money for their long- term growth and other activities. Debenture is a type of debt capital and it accounts for debt on the balance sheet of the company which issues it.

Debentures are unsecured meaning the investors do not have any claim to the company’s assets in case any default occurs. It is therefore a type of bond which is issued without any collateral for medium to long- periods. Debentures are based solely on the creditworthiness of the organization that issues it.

They are therefore issued typically by large organizations that have triple A credit ratings. This form of investment allows corporations to use their privileged status to their advantage and borrow money without any security (Nwoye 2021).

Some debentures which are issued by large corporations are converted into ownership shares of the company which issued them therefore converting them into debt. Some examples of debenture include treasury bonds and treasury bills.

Main attributes of debentures are that they are a type of movable property, they are issued by the company as a certificate which states the indebtedness, they are a safe investment and do not involve capital erosion, they have a low rate of interest than bank loans and bank overdrafts, and a fixed interest is earned by debenture holders (Sen and Mehta 2018).

What are the Different Types of Debenture?

Debentures are of various types and the different types are issued based on the objectives and needs of the company. Major types of debentures include the following:

1. Registered Debentures-

These types of debentures are registered with the company. They are transferred only via transfer deeds. The interest associated with the debenture is paid only to the names of those that appear on the register of the company.

2. Bearer Debentures-

These type of debentures do not need to be recorded in the register of any company. They can be transferred only through delivery and do not require a transfer deed for the same. It is the under the entitlement of the bearer or holder of these debentures to receive the interest.

3. Secured Debentures-

Such type of debentures are secured by a charge on the company assets. Secured debentures give the holders a right to recover the principal amount and any unpaid debenture interest out of the assets that have mortgaged by the company (Acharya and Koirala 2020).

4. Unsecured Debentures-

These type are not secured and do not possess any charge on the assets of the company. With respect to the unpaid interest or the principal amount, unsecured debentures have no claim on the assets of the company.

5. Redeemable Debentures-

They are issued for a fixed time period and on the date of expiry, it is expected from the debenture holders to pay back the principal amount (Jain 2021).

6. Non- redeemable debentures-

These type of debentures are not redeemable in the lifetime of a company. They are paid back only on the company’s liquidation.

Apart from above mentioned types, some other types of debentures include convertible debentures, non- convertible debentures, first debentures and second debentures.

Important Factors to Consider when Buying a Debenture

When buying a debenture then the following factors should be considered: credit rating, coupon rate, credibility of the issuer and additional features or perks. A number of agencies currently assess the credit ratings and therefore help to gauge the quality of a bond with respect to the credit performance.

A rating of AAA or AAA+ is always preferred. The coupon rate is the rate of interest that is offered by the issuer. A high rate implies an increased risk debt instrument and a low rate means a low risk debt instrument. The best factor to judge the creditworthiness is the financial health of the company/ issuer.

Possessing knowledge of the credit rating and need for additional capital or funds are factors that help in making decisions relating to investment. Additional features also help in attracting investors (O’Neal 2018).

What Is The Difference Between Bond And Debenture?

Bonds and debentures are both popular debt instruments, however both differ from each other in various aspects. Bonds are used by agencies of the government, private corporations and financial institutions and they are essentially loans which are secured against physical assets. Debentures differ from bonds in the aspect that they are unsecured debt instruments which are not backed by collateral and are issued by private companies.

It is only the credit rating of any company which issues the debenture that acts as the underlying security. Debentures are used as a tool to raise fund. Debentures are of short- tenure usually whereas bonds are considered to be long- term investments. Bonds are practically safe to be issued, however debentures carry a high risk since they are backed solely by the credit and faith of the issuing party (Parameswaran 2019). 

Rate of interest offered by bonds are low, but that offered by debentures are usually high.  Payments of bonds are based on an accrual basis whereas debentures are paid back on a periodical basis. Bonds are not converted into equity shared but debentures often provide this facility. Convertible debentures allow the bearer to convert debenture into equity shares.

What are the Pros and Cons of a Debenture?

Pros of a debenture include not giving away the right to take part in management of the company, it is tax deductible expenditure which saves income tax, cost is low in comparison to equity shared and preference share and they offer great advantages during periods of inflation. It also encourages the growth of a business by encouraging funding for a long- term. It is highly cost- effective when compared to other types of lending (Ikpefan 2016).

Cons of a debenture include reduced borrowing capacity of the company after a debenture, and a burden on the company to repay the debentures which makes it a risk for the company during times when the earning of the company start fluctuating (BIEmAN and SMTH nd.).