EXPLANATION OF DEBENTURES WITH ITS FEATURES

EXPLANATION OF DEBENTURES WITH ITS FEATURES

A debenture is a type of instrument of long-term debt that any corporation and government can resort to for raising capital, usually without pledging any specific assets of the firm. Unlike secured bonds, debentures are not pledged on any specific asset but solely based on the creditworthiness and reputation of the issuer; thus, they remain unsecured in nature. A fixed interest rate is associated with a debenture, which becomes payable to investors at certain periodic intervals. Interest payments provide periodic income to holders. Any debenture has a maturity date on which the amount that is principal has to be returned to the holders of such a debenture.

They may either be convertible or non-convertible; convertible debentures can, under certain conditions specified, be exchanged for equity shares of the company issuing them, offering potential upside in equity. Some debentures bear call or put options, which provide for early repayment or redemption, subject to certain conditions. As rated by credit rating agencies, the debentures carry an evaluated level of risk to advise investors.

Some debentures are marketable; on the other hand, some find their ways into the stock exchange, where holders can buy and sell them prior to maturity. While debentures are quite flexible for issuers to issue without diluting equity ownership, they do impose a fixed financial obligation in the sense that the interest has to be paid off regularly and the principal repaid at maturity, which is irrespective of the issuer's condition.

FEATURES OF DEBENTURES

A debenture is a type of debt instrument that is not pledged or mortgaged by physical assets or collateral. The debentures are only backed by the general creditworthiness and reputation of the issuer. Both corporations and governments issue debentures quite frequently to raise capital or funds.

1. Interest Rate (Coupon Rate):

A debenture generally bears a fixed interest rate, payable at periodic intervals, which is fixed in advance. Such an interest rate is called the coupon rate.

2. Maturity Date:

A debenture has a maturity date on which the face value is repaid to the holder.

3. Convertibility:

Some debentures can be converted into shares of the company issuing them, on the discretion of the holder of these debentures. These types of debentures are known as convertible debentures.

4. Redemption:

Debentures can either be redeemable or irredeemable {perpetual}. When they are redeemable, they have a specified date of maturity, while if they are irredeemable, then no fixed date of redemption is specified.

5. Secured vs. Unsecured:

Whereas most debentures are unsecured, some are secured against specific assets. Secured debentures offer lower risk for the investors by giving them a claim on some assets in case the issuer has defaulted in the payments.

6. Trust Deed:

The debenture trust deed is a legal document outlining the terms and conditions of the debenture issue. This agreement is drawn up between the company that issues the debentures and a trustee who represents the holders of the debentures.

7. Ranking:

In liquidation, the debenture holders have a priority over the equity shareholders but not over the secured creditors.

8. Rating:

Most debentures carry an embedded credit rating by rating agencies. Such rating reflects the credit risk for the institution that issues these instruments, therefore helping the investors in making effective decisions.

9. Interest Payments:

The interest on the debenture is paid before payment of dividend to shareholders and hence becomes the first charge on the company.

10.Transferability:

Most debentures can be freely traded in the open market, hence availing liquidity to the holders.

11. Tax Benefits:

Interest paid on debentures is generally deductible in the issuing company's hands and hence very appealing as a source of finance.

12. Issuing Obligation:

The principal amount, along with the interest, has to be compulsorily returned by the issuer according to the terms of the debenture agreement.

Benefits of Debentures

1.Stable Income:

Regular Interest Payments: One of the main advantages associated with debentures is that they have fixed interest payments payable to the holder at regular periods, thus providing a stable income stream to the investor. This kind of predictability is always very attractive to risk-averse investors, such as retirees looking for steady cash flows.

Higher Yields Compared to Savings Accounts: Generally, debentures yield higher interest rates compared to traditional savings accounts or government bonds; hence, this vehicle is quite attractive to income-focused investors.

2. Priority in Bankruptcy:

Higher Claim on Assets: In the event of liquidation, the debenture holders' claim on the distribution of assets ranks higher than that of the equity shareholders. Therefore, there are higher chances of recovering their money.

Low Risk: As such, it is less risky for debenture holders as compared to shareholders, who can lose their entire investment in case of bankruptcy.

3. No Dilution of Ownership:

Maintains Control: There is no dilution of ownership of the current shareholders since debenture holders do not have voting rights in the company. This feature helps the company to mobilize funds without hampering control and decision-making authority of the existing owners.

Attractive to Existing Shareholders: This feature makes this source of funds especially attractive to the existing shareholders who desire to avoid the dilution of their shares and retain their influence on corporate governance.

4. Tax Benefits:

Interest Expense Deduction: The interest paid on debentures is generally deductible by the company issuing them, thus reducing their taxable income. The net cost of borrowing could, therefore, be reduced.

Attractive to Issuers: Due to the tax advantage, debentures are more attractive to companies offering finance through this source. The net cost of interest is reduced by the tax saved on its payment.

5. Flexibility:

Customizable Terms: Firms can design debentures with a host of terms and characteristics—interest rates, maturity dates, convertibility, and the like—to suit their financing requirements and market conditions. This makes debenture financing, therefore, very versatile in nature. Convertible Options: There is an option for the investors in convertible debentures to convert their debt into equity under certain conditions, thereby bringing in the fixed income and potential appreciation in equity. Attractiveness to Investors:

Wide Appeal: Debentures can appeal to a wide pool of investors, such as those investing in fixed income securities and others who see the potential of equity participation through convertible debentures.

Liquidity: The listed ones provide the added advantage of liquidity, which allows the buying and selling of these instruments in the secondary markets, making investing easy and investment easy.

Disadvantages of Debentures

1. Fixed Obligations:

Mandatory Payments: Interest is payable at regular intervals, and principal is returned at maturity, irrespective of the issuer's financial condition. This might turn out to be a huge financial liability, more so during a slowdown or when cash inflows are less.

Default Risk: Inability to service such fixed charges may lead to a default and has negative implications with regards to credit rating and financial health of the issuer. Credit risk:

Issuer's Creditworthiness: Because debentures are not collateral based, the creditworthiness of the issuer is all the more important. If the financial condition of the issuer deteriorates, the chances of default are more likely to happen and may also cause losses to investors.

More Risky than Secured Debt: Because debentures do not have any direct backing of assets, it is riskier when compared to the secured debt instruments, and the only reliance that an investor can rely on is the general ability of the issuer to repay.

2. Interest Rates:

Interest Rate Sensitivity: The market value of the debenture moves inversely with interest rates. If interest rates go up, it typically reduces the value of outstanding debentures since new issues are available at higher yields which make older ones less attractive.

Market Volatility: This may result in fluctuations in the market price of such debentures, affecting the marketability of such instruments and return to investors.

3. No Voting Rights:

No Right to Vote: The debenture holder cannot influence any decision taken by the corporate house since there is no voting right in the issuing company. This may be a drawback for investors who wish to contribute to company decisions.

Limited Control: It is also a disadvantage at times of restructuring of corporation or some key strategic changes where debenture holders have no say.

4. Call Risk:

Early Redemption: In the event that any type of debenture is callable, it simply means that the issuers have the right to pay it off before its maturity date, usually at a premium. This may be in the interest of the issuer but presents a reinvestment risk to the investor, who has to reinvest the returned principal at lower interest rates.

Unfavorable Timing: Among the unfavorable timings that investors may experience is the chance of call risk more so in a case where the debentures are called when interest rates have fallen thus reducing the possible income to be earned from reinvestment.

5. Marketability:

Liquidity Concerns: While some debentures are traded on the stock exchanges, others may not have that liquidity. For instance, it can be very challenging to sell their debentures quickly, or without moving the price.

Market Price Fluctuations: The marketability of the debentures may be influenced by the issuer's credit rating, movements of interest rates, or the general condition of the market, all of which could affect their prices.

6. Dilution upon Conversion:

Convertible Debentures: In the case of convertible debentures, holders exercising them to be converted into equity shares may result in a dilution in EPS for the existing shareholders. This kind of dilution may filch the value of the share and may result in a drop in the stock price.

Impact on Shareholders: The potential dilution may be viewed adversely by the existing shareholders because it reduces their proportionate ownership and control over the company.