Characteristics of Debenture And How do Debentures Work?

A debenture is an instrument that is used by a lender, such as a bank, upon the provision of capital to different organizations and individuals. This instrument enables the lender to assure loan repayments against the borrower’s assets, even if the borrower defaults at the time of payment.

A debenture can grant either a floating charge or a fixed charge. A charge which is usually bonded to the assets such as raw materials, shares, or an intellectual property which implies that the assets may change over time, and the borrower has the right to sell them without the lender’s intercession is termed as a floating charge. But it is pertinent to mention here that floating charges may become fixed if the borrower defaults.

A fixed charge is usually set against assets that are tangible such as the property which enables the lender to take ownership of the borrower’s assets. The lender has the right to sell them off in the event of a payment default. However, under a fixed charge, the borrower is not able to sell the asset without the lender’s consent.

How do debentures work?

A debenture is issued by the borrower via an agreement called an indenture. The format and content of debenture instruments may vary from country to country however, it must outline points such as the amount of the loan, its convertibility, maturity date and, interest rate. After the agreement, the investor lends the funds to the borrower and awaits repayments at the agreed interest rate.

Let’s understand how this instrument works through this example. Let’s say a company by the name of Crystal (Pvt.) Ltd issues a debenture to the value of $100,000, redeemable on 31 December 2020. This date shows the time when the company will be entitled to receive the loan back.

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It bears 8% interest per year, payable on 31 August every year. It has been agreed in between both of them that the investor is offered the loan at a fixed charge. If Crystal (Pvt.) Ltd defaults on the payment date, the investor bears the right to sell the company’s assets to raise the capital needed to fulfill the loan amount.

Characteristics of debentures

Debenture instrument possesses the following characteristics;

Written Promise

It is a written document that the company (borrower) issues to the lender which acknowledges a loan or debt.

Company Seal

The debenture instrument is a certificate that the company (borrower) issues under its seal (debenture deed) which depicts the amount and date of repayment of the debt along with the rate of interest.

No Controlling Power

The debenture holders do not possess the power to control the operations of the company since they are the creditors of the company. They are not entitled to vote to elect the directors and to decide any managerial policy.

Maturity Period

The debentures consist of long term pre-set maturity periods so it is the long term source of finance.   The maturity period of debentures is usually between 10-20 years. They are repayable at the end of their maturity period. At the due date, the company repays the principal investment amount to the holder of the instrument.

Borrowed Funds

It is the component of the borrowed fund capital which makes the holders of debentures as the creditors of the company.

Fixed-Rate of Interest

This financial instrument has a fixed rate of interest and is paid every financial year and due to this reason investor also call debentures as fixed cost bearing capital.

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Claim in Income

Let’s assume that a company does not have enough funds to pay interest on debenture as well as dividend on preference shares and equity share. In this situation, the company will have to pay interest on debentures to the debenture holders first, and then with leftover funds, it can do the other payments.

The holder of the debenture instrument can legally enforce its right. They are given priority over the equity and preference shareholders. They have a priority of claim in the income of the company over others. They are entitled to get a fixed rate of interest at the end of every financial year.

Priority Claim On Assets

The claims on the assets of the company arise at the time of liquidation or reorganization of the company. The debenture holders also have precedence over the equity and preference shareholders in respect of their claim on the assets. The creditors are allowed to get only the principal amount that they had paid along with any unpaid interest.

In order to bring down the risk of losing the principal amount, these instrument holders choose to secure the loan against the specific asset. However, if they have the confidence in the earnings of the company that it will satisfy their claims, they may not call for the security of loan and may accept the debenture even not having not any specific asset pledged.

Those debentures that possess any charge against any specific asset are addressed as secured creditors and others as unsecured creditors.

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Appointment of Trustee

When the company decides to sell debentures to the general public in a large number then it usually appoints a trustee. The trustee is appointed to ensure the firms that are borrowing are able and fulfill the contractual obligations. The bank or financial institutions can act as a trustee.

The biggest advantage of debentures is that the company can get its needed funds without cutting equity because debenture is a form of debt hence, the equity of the company remains unaltered.

Another vantage a company gets by issuing debenture is that interest which is paid on debentures is a charge against profit therefore, it is a tax-deductible expense and is useful while tax projection. Further, the debenture holders hold very minimum risk because the loan is secured and the interest is payable even in the case of a loss to the company.

However, the instrument does have some limitations, the biggest of one is the interest payable to debenture holders is a financial liability for the company which is even payable even in the event of a loss.

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