What is Debenture? (Definition, Types, Pro and Con)

Definition:

Debentures refer to unsecured bonds of the corporation. Debentures are not secured by any specific company. The debenture holder becomes the creditor general in case of liquidation of the company. Hence, investors try to look earning power of the company as a basic prerequisite for investment or raising debt.

Although unsecured, debenture holders get priority over the equity shareholders. This means that debenture holders will be paid before any amount is paid to equity or preference shareholders. In simple words, a debenture is an acknowledgment of debt, the organization has taken from the public.

These are important financial instruments for raising funds. It contains fixed coupon bonds. The companies law and regulations generally include bonds and debenture inventory as part of the debenture.

The debenture types are based on their mode of redemption, convertibility, security, transferability, type of interest rate, tenure, coupon rate, redemption, etc. To put it simply, debentures are financial instruments with flexibility. The contract between the company and the debenture holders shall determine its true nature.

Types of debentures (Examples)

There are many kinds of debentures available in the markets. This financial instrument is known for flexibility as it can be modified as per one’s requirement. The popular kinds are :

1) Redeemable and irredeemable i.e. perpetual debentures

When the date of redemption is given for debentures, these are redeemable debentures. The debentures carrying not specific time of redemption are irredeemable debentures with the perpetual feature.

Perpetual debentures are redeemed as per mutual consent or at the time of liquidation. These are debentures from viewpoint of tenure.

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2) Secured and Unsecured debentures

Secured debentures have charges made on the properties or other assets of the company as collateral. The charge can be either fixed or floating. The fixed charge is made against assets when the purpose is other than working capital requirements. When the purpose is working capital requirements, a floating charge is made.

On the other hand, unsecured debentures do not have any charge. A floating charge however may be established by default. These charges are from the viewpoint of the security feature of debentures.

A secured debenture is secured by some sort of charge on an asset or group of assets, hence, popularly called mortgage debentures as well. Unsecured debentures are agreed upon solely on the reputation of the company in the market. These are also called naked debentures.

3) Convertible and Non-convertible debentures

These debentures are from the viewpoint of convertibility. Debentures that are changeable to equity shares or in any other security either at the choice of the enterprise or the debenture holders are called convertible debentures.

Debentures that cannot be converted into another form of equity or debt called Non-Convertible Debentures. These debentures are widely circulated in the market.

4) Registered and bearer debentures

Registered debentures are filed in the register kept by companies. The various details comprise the name of holders, addresses, and particulars of holders. These kinds of debentures can be moved by performing normal transfer deed.

Bearer debentures on other hand mean anyone who holds the debenture certificate is a debenture holder. Such a person can receive the interest coupon attached to the defender. These debentures are from viewpoint of registration.

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5) Zero-coupon and specific coupon debentures

Zero-coupon debentures do not carry any coupon rate i.e. it does not pay any interest. However, to compensate the holders, the maturity or redemption amount is set at a good premium.

The amount of interest equivalent is recovered by the investor by holding the debenture till the duration associated with the instrument. On other hand, debentures with the interest rates mentioned are called coupon debentures or specific coupon debentures. These debentures are from viewpoint of coupon rate point view.

6) Subordinated debenture

These debentures have priority over any other kind of debt in case the company goes into liquidation. These are also popularly called subordinated debt or junior debt. These debentures have higher returns as they undertake more risk.

Pros and Cons of Debentures

Pros of Debentures

  • Investors who want a fixed rate of returns with lower risk prefer debentures over equity. The funds raised through debentures do not dilute the ownership structure. Hence, companies prefer debentures as a result of this feature. The cost of debenture is less than that of equity or preference. Further interest paid is tax-deductible.

Cons of Debentures

  • After issuing debentures, the further restriction is imposed on the borrowing capacity of the company. Debentures affix a certain permanent burden on the company to pay interest. So, when the earnings fluctuate, the company would see an accelerated downturn in business.
  • In the case of redeemable debentures, the company has to provide for principal repayment even during the financial crisis or liquidity crunch faced by the company.
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