Debentures: Meaning, Features, Types, Benefits and Risks
A business may require loans to expand or carry out new projects. These loans can be taken from investors who wish to earn higher interest rates than ordinary fixed deposits. Such loans are called Debentures and are taken from investors in exchange for a pledge to repay their loan with interest.
In this blog, we will explore the meaning of debentures, its types, benefits, risks, and suitability.
What Is Debentures
Debentures are long-term financial instruments issued by a company, generally without any collateral, in order to borrow money from the public. It is an arrangement between the issuer and the holder. Instead of issuing new stock, businesses often use them to obtain medium to long-term capital without diluting ownership. When a company or a government issues debentures, investors receive interest payments at predetermined intervals until their maturity date, when the principal amount is repaid.
Types of Debentures
There are various classifications of debentures in the market. They are mentioned below:
- Convertible (CDs) and Non-convertible debentures (NCDs): CDs are the debentures that can be converted into a specified number of equity shares after a predetermined period and NCDs are the securities that can not be converted into equity shares.
- Secured and Unsecured Debentures: Debentures that are backed by a specific asset, which provides investors with an extra layer of protection, are secured debentures whereas debentures that rely solely on the issuer’s creditworthiness without any collateral are unsecured debentures.
- Redeemable and Irredeemable (Perpetual) debentures: Debentures that are issued with a fixed date on which the principal amount will be repaid are Redeemable debentures while debentures that have no fixed maturity date and carry on forever are Irredeemable debentures. In irredeemable securities, the issuer makes interest payment perpetually.
- Callable and Puttable Debentures: Debentures where the issuer has the right to redeem the debentures are Callable Debentures and debentures where the holder has the right to sell their debentures back to the issuer before maturity are Puttable Debentures.
- Zero coupon Debentures: These debentures are issued at a discount and redeemed at face value. The twist is that these debenture holders do not receive any interest payments.
Features of Debentures
Both issuers and investors find debentures appealing due to several important characteristics.
- Fixed Interest Rates: Debentures have a fixed interest rate, which gives investors a steady source of income, typically semi-annually or annually.
- Principal Repayment: Debentures generally have set maturity dates, which means issuers repay the principal amount to the debenture holder at the end of the maturity period, which could be anything from a few years to decades.
- Credit Rating: Rating agencies often evaluate the creditworthiness of debentures to assist investors in determining the level of risk.
- Liquidity: Debentures can be traded in the secondary market, allowing investors to liquidate their debentures.
- No ownership dilution: Issuing debentures does not dilute the ownership of existing shareholders as they are debt instruments.
Benefits of Debentures
Debentures are issued because they offer a lot of advantages, some of them are mentioned below:
- Regular Income: The interest payments made by debentures provide investors with a steady income stream.
- Low Risk: As compared to equity investments, debentures are generally less hazardous as they offer fixed return and priority in case of liquidation.
- Security: Debentures are regarded as more secure investments because of their stable reputation, which helps to protect the principal amount over time.
- Capital Preservation: Debentures help in capital preservation as the principal amount is repaid at maturity.
- No Dilution: Debentures do not cause any dilution in the company’s shareholding equity, thus preventing any major backlash from shareholders of the company.
Risks
While debentures are a great way for the company to raise capital while preventing dilution, they do come with their set of risks. Some of the risks are mentioned below:
- Credit Risk: There is always a chance that the issuer may stop making interest payments or won’t pay back the principal.
- Lack of Control: Debenture holders usually lack voting rights, which reduces their ability to influence corporate choices.
- Liquidity Risk: Some debentures lack liquidity, making it difficult to trade them in the secondary market.
- Interest Rate Risks: Rising interest rates decrease the market value of existing debentures making them less appealing.
Suitability of Debentures
Debentures are an attractive investment choice for a wide range of investors. They offer a means of earning consistent returns with comparatively reduced risk for cautious investors. Due to their extra security, risk-averse investors tend to gravitate towards debentures.
Debentures are especially tempting to those seeking consistent income because they provide a steady income stream via fixed-interest payments. Investors aiming to support their financial objectives with steady cash flow can find this a reliable investment vehicle.
In summary, secured or highly rated debentures are desirable for investors who prioritize capital preservation above risk. These investors value stability and safety above bigger returns, making debentures a better option for achieving their investing goals.
Debentures are flexible investment instruments that can be tailored to meet a variety of risk profiles and financial objectives, thereby meeting investors’ diverse demands and preferences.
Conclusion
To summarize, debentures are an important financial tool that allows businesses to raise money and provide investors with a reliable source of income. By having a thorough understanding of these products’ kinds, features, rewards, and risks, investors can make wise selections that are in line with their financial objectives and risk tolerance. Debentures can be an essential addition to your portfolio in order to attain financial stability.
Frequently Asked Questions (FAQs)
How are debentures different from bonds?
While both are debt instruments, debentures are typically unsecured, while bonds are often secured by collateral or specific assets. Additionally, companies generally issue debentures, whereas the government and companies can issue bonds.
How can I buy Debentures?
When a company issues new debentures, you can purchase them through your broker. Debentures can also be bought in the secondary market as they are traded amongst investors.
What is the maturity date of a debenture?
The maturity date is when the issuer repays the principal amount to the debenture holder. The maturity date of a debenture can range from a few years to several decades.
How can I assess the risk of a debenture?
The risk of a debenture can be assessed by checking the credit rating, evaluating market conditions, considering the interest rate environment, and reading the terms and conditions of the debenture.
Can debentures trade on the secondary market?
Yes, Debenture can trade on a stock exchange or over-the-counter markets, providing liquidity to investors.
