When it comes to raising funds, companies have many options. One is to issue a bond on the open market. A bond – a type of debt instrument – enables firms to borrow money from investors instead of borrowing from a bank. The firm is the bond issuer, the investor is the lender, and the bond represents an IOU between them. Firms can issue both unsecured and secured bonds to raise funds. A debenture is a type of unsecured bond. It enables businesses to raise financing without putting up collateral, diluting equity, or sacrificing share value.
For many firms, a bank loan can be prohibitively expensive. Plus, many banks place restrictions on borrowers that can limit their business activities. There are no such restrictions when borrowing via bond issuance. Moreover, the company’s borrowing cost is also lower with a bond because they would pay a lower interest to investors compared to the interest they would have to repay a bank.
Debentures Explained
A debenture is a type of long-term business loan an issuer takes from investors on the open market. The bond represents a contract between the issuer and investors, which makes debenture holders (owners) the issuer’s creditors.
It is a type of unsecured bond since it is issued without putting up collateral. It is only the issuer’s creditworthiness, reputation, and history of positive cash flow that back the debenture. That’s why these bonds are usually issued by well-known issuers whose ability to repay creditors is beyond doubt.
Furthermore, the issuers can offer lower rates of interest because they can attract investors based on the strength of their creditworthiness alone. That said, debentures still offer higher interest rates than other fixed-income instruments like secured bonds and bank fixed deposits (FDs).
Smaller issuers or issuers with lower credit quality can also issue debentures. However, to attract investors, they will have to offer higher interest rates to compensate for the increased risk associated with these debt instruments.
Both companies and governments can issue debentures by offering a fixed rate of interest. Like other bonds, a debenture also pays interest payments (aka coupon payments) at some fixed period.
The maturity period of most debentures is five to 10 years. However, since it is “marketable” security, holders can sell it to other parties before this period elapses. Debentures appear on company balance sheets in the liabilities section.
A debenture is a suitable long-term funding option for companies that:
- Don’t want to issue new shares and dilute their existing equity
- Are unwilling to tie up their assets to back up the bond issue
- Don’t have collateral to obtain a traditional secured loan
Convertible Debentures vs Nonconvertible Debentures
There are several ways to categorise debentures. One is by the transfer mechanism. A debenture whose transfer must be organised through a clearing facility is known as a registered debenture. It is recorded in the company’s register of debenture holders.
The clearing facility alerts the issuer to any ownership changes so they can pay interest to the correct holder. In contrast, a bearer (owner) debenture is not registered with the issuer, and the holder is entitled to earning interest simply because they hold the bond.
Another way to categorise debentures is as redeemable or irredeemable. With irredeemable or perpetual debentures, the issuer is not obligated to repay the bondholder in full by a particular date. With a redeemable debenture, the issuer must fully repay their debt by the bond’s maturity date.
A third categorisation method is convertibility. A convertible debenture can be converted into the issuer’s equity shares after a specific period and under the conditions specified in the debenture certificate. A nonconvertible debenture (NCD) cannot be converted into equity.
Drawbacks of Convertible Debentures
Convertible debentures are suitable for investors who want the option of converting the bond to equity sometime in future. They may believe that the company’s share prices will rise and thus give them high returns if they convert and sell their holdings as stock.
The possibility of conversion helps to offset some of the risks the investor takes on when investing in this unsecured instrument. Nonetheless, it also comes at a price. Convertible debentures pay a lower interest rate compared to other fixed-rate debt instruments, so the returns are also lower. Additionally, if the share price doesn’t appreciate, the bondholder may not earn the higher returns they expected.
Another drawback is the risk of issuer default. If this happens, the company will be unable to pay back the principal to bondholders. And since there is no underlying collateral, the holder has no recourse to recover their investment.
The Advantages of Nonconvertible Debentures
Like convertible debentures, NCDs also repay bondholders at a fixed interest rate and a fixed period. NCDs also have a fixed maturity date when the bondholder will receive their entire principal amount.
The only drawback is that NCDs offer slightly lower interest rates compared to convertible debentures. However, they offer many more benefits, including higher liquidity and lower risk.
1. Lower Risk
The fixed interest rate and set maturity period, along with the issuer’s creditworthiness and credit rating (issued by rating agencies like CRISIL, ICRA, CARE, etc.) lower the investor’s risk. Additionally, since the NCD cannot be converted into equity, the bondholder does not face the risk of a possible fall in the share price resulting in losses.
2. Higher Liquidity
NCDs have higher liquidity because they can be bought or sold anytime in the secondary market. This trading ease is possible because it is mandatory to list NCDs on a stock exchange. Due to higher liquidity, holders who require a sudden influx of cash can simply sell their holdings in the secondary market.
3. Higher Returns than Some Other Fixed-Income Instruments
NCDs offer higher interest rates than bank FDs. They also offer the same repayment flexibility as FDs, i.e., monthly, quarterly, half-yearly, or annually. Some issuers also offer a cumulative payout option.
4. Possibility of Default
All debentures, including NCDs, are backed by the issuer’s creditworthiness. So, unless something drastic happens, the probability of issuer default is quite low so holders usually earn expected returns and get their principal back on maturity.
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