Debentures are fixed-income instruments that provide a fixed rate of return to the investor over the tenure of the product. The word debenture comes from the Latin word ‘debere’, which means to borrow. The companies issuing the debentures classify it as debt and are usually used as a medium to long-term loan to raise capital. There are different types of debentures based on the requirements of the company. It can be further segregated on convertibility, registration, redemption, tenure, coupon, etc.
The interest rate or coupon of the debenture is linked primarily to the creditworthiness of the underlying company, so a company with a good credit rating can raise money at lower interest rates compared with a company with a lower credit rating. Debenture interest falls under the expense list of a company’s financials. So, the interest on the debentures is usually paid before a company pays a dividend to its investors. The interest is paid out even if the company is not making any profit.
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How are Debentures Structured?
All debentures adhere to a standard structuring method and have similar features, which are as follows:
- The first step is to draft a trust indenture. It is a contract between the entity that takes care of the interest of the bondholders and issuing entity.
- In the second step, the coupon rate is fixed. It is the interest rate that the enterprise will pay the investor or the debenture holder. The rate can be floating or fixed, based on the credit rating of the enterprise.
Note: Debentures can be either convertible or non-convertible into common stock
Features of a Debenture
Here are the key features of a debenture:
Promise
It is a written promise or guarantee by an issuing company that is obligated to be a particular sum to the holder.
Face Value
It is a random number fixed by an issuer that is generally displayed on a company’s balance sheet.
Time of Repayment
It is a debt instrument generated by a company. In this debt instrument, maturity is always declared. In simple words, it mentions the time of repayment of both the principal and interest amount on maturity.
Interest rate
The holders of a debenture get a fixed rate of interest payment, either annually or half-yearly. The interest rate for such debt instruments differs based on the company, the type of business operations and the present market condition.
Assurance of repayment
According to the deed, debentures are long-term debt instruments that prove a guarantee of repayment on a particular due date. Not to mention, this debt instrument can be redeemed at a premium, par, or discount.
Parties to Debenture
- Company: A company is an entity that is responsible for borrowing money
- Trustee – –A trustee is a party that helps a company to manage the holders. The enterprise prepares an agreement between the holders and trustees, called the Trust Deed. This deed comprises company rights and obligations of holders, etc.
- Debenture Holders –– Debenture holders are entities that offer loans to companies and get a debenture certificate as proof of participation.
- No Voting Rights– The company holders/creditors do not have voting rights in normal meetings. The holders can vote only when the company seeks their judgment during special circ*mstances.
- Listing– It is required to get listed with a minimum of one stock exchange.
What are the Types of a Debenture?
- Secured debentures- These aredebenturesthat are generated against collateral. In simple words, the assets of the issuing company are charged.
- First mortgage or preferred debenture- It is also called a Preferred Debenture. It is the primary hold on the asset that safeguards the mortgage. In the event of a default, it has priority over all the rights of an asset.
- Second mortgage or ordinary debenture- The second mortgage, also called standard company debenture, is serviced during realisation.
- Unsecured debentures- Such debentures are issued with no charge against the issuing company’s assets.
- Convertible debentures- In convertible debentures, the holders have the right to transform the debenture holdings into the company’sequity shares. The company mentions the particulars of the holder’s right, conversion date, trigger date of conversion, and other conditions during the time of the issue.
- Non-convertible debentures-Such debentures do not allow the holders to transform their debt into equity. Compared to regular debentures, theinterest ratefor such instruments is relatively higher. Hence, these instruments preserve their debt character.
- Redeemable debentures- Debentures that are due for repayment at the end of a particular period during the entity’s lifespan are termed redeemable debentures. Such debt instruments are redeemed either in small instalments or lump sums, at face value or premium.
- Irredeemable debentures- Such debentures are repaid within the lifespan of an enterprise. While liquidating the company, redeeming such debentures is possible.
- Registered debentures-When the information about the holders, such as an address, names, etc., is stored in a distinctive register at company headquarters, it is called registered debentures. It is not possible to transfer such debentures by delivery. They need a transfer deed.
- Bearer debenture- For such debentures, no particular record of its documents is stored in the company’s register. Such debentures are transported through simple delivery.
Example of Debenture
A good example of a debenture is T-bonds. T-bonds assist finance projects and provide funds for regular government operations. Some T-bonds trade in the secondary market via a broker or financial institution.
Benefits of Debentures
Benefits to Debenture Issuers
Economical loan: The interest payable on the debenture is lower than the rate of return payable to equity and preference share investors.
No loss of management control:Since debenture issuance does not dilute the organisation’s stake, there is no decline in management control over the company’s day-to-day working.
Tax friendly: Since the interest is paid before the dividend, it is treated as an expense, thus reducing the tax liability of the organisation.
Benefits to Investors
Regular interest income: Basis the frequency of coupon payable, the investor gets interest income periodically based on the coupon rate agreed upon in the term sheet of the debenture.
Payment preference: Since debenture holders are classified as creditors, they are given priority over equity shareholders in case of liquidation of the company’s assets because of bankruptcy.
Regulated: The debentures issuance in India falls under the aegis of the market regulator – Securities and Exchange Board of India (SEBI), and thus are well regulated under the norms and guidance providing investor protection.
How do Debentures Work?
The issuer of the debenture agrees upon an interest rate/coupon basis the requirement and credit rating of the company/issue. This is then set up to release during the offer period when investors can purchase the securities in the primary market either directly from the issuer or the distribution network, including platforms such as Aspero.
Once the debenture is sold, it is listed on the secondary market and is traded based on the demand and supply dynamics. Here, platforms such as Aspero and distributors play an essential role in debenture transactions.
Why Debentures is for You?
Aspero provides trade and investment across various types of bonds, including debentures and their various varieties, such as market-linked debentures and non-convertible debentures (NCDs). The platform provides unparalleled efficiencies, including digitisation, access to repositories, and actionable insights for all counter-parties in the sale within minutes. Aspero also provides efficient credit and price discovery, and liquidity in the secondary market for non-AAA-rated papers.
Debenture Stock & How to Buy
Debenture stocks are loan agreements between an organization and its holders. The holders are provided with dividends from the profit earned by the organization at certain intervals.
Furthermore, debenture stock functions the same way as preferred stock does. Also, debenture stocks have the same investment risk as any other equity. However, debenture stocks are backed by a trust deed.
You can buy debenture stock when it is announced by a company or from the secondary market when it is traded.
Key Features of Non-Convertible Debentures and how to buy NCDs
Here are the key features of non-convertible debentures:
Tenure: Non-convertible debentures cannot be converted into stocks or debt categories since they fall under the debt segment.
Non-convertible debentures have a set maturity date. The interest and principal on such instruments can be provided monthly, annually, or quarterly based on the fixed tenure mentioned.
Interest Payouts: Non-convertible debentures provide a high-interest rate. The interest rate ranges from 7-9% at maturity. The interest for such payouts is done either monthly, quarterly or annually. In addition to it, NCDs provide a cumulative option too.
Liquidity: They benefit investors with their maximum returns and liquidity. Considered low-risk investments, NCDs offer tax benefits compared to convertible debentures.
Safety: Non-convertible debentures are either secured or unsecured. It depends on the principal sum and the interest rate generated by the company providing debentures.
The issuing enterprise starts the public issue of NCD for a particular period. Such debentures are registered on the stock exchange. After that, they are listed as mentioned by the company.
Once it is listed on the stock exchange, it is possible to invest in non-convertible debentures via brokers or any other source that helps to access the stock exchange.
What to Consider Before Investing in NCDs
Here is the list of the things to consider before investing in NCDs:
NCDs are prone to risks concerning business management and funding. Thus, the credit rating can be severely impacted if the turnover is negatively influenced. The company must acquire extra funds from non-banking financial corporations or banks to compensate for the impact.
Thus, it is recommended to keep the following things in mind before selecting a company for NCD:
Credit Rating of the Issuer
Select a company with an AA rating or more since such ranking determines the company’s potential to raise cash from its operations and sustainability. This parameter shows the financial status of the company.
CAR (Capital Adequacy Ratio)
CAR measures the capital available to a company and checks if the funds are adequate to sustain a potential loss. Make sure that the firm you want to invest in has a minimum15% CAR and has usually maintained the same.
ICR (Interest Coverage Ratio)
ICR analyses the ability of the firm to settle the loan interest at any possible time. This makes sure that the company can deal with any potential evasions.
Level of Debt
A background check on the company’s asset quality can help NCD investors in the long run. Make sure not to invest in a company where more than 50% of the total assets are assigned towards unsecured loans.
Provisions for NPAs
The business enterprise should keep at least 50% of the assets towards NPA. It will serve as a positive sign of their asset quality. In case the quality declines because of bad debts, it is a warning signal.
Tax Slab
NCDs are very attractive for investors in the 10-20% tax slabs.
FAQ
What is the coupon rate?
The coupon rate is the interest offered by the debenture, and this coupon/interest is paid in various frequencies to the investor, including monthly, quarterly, half-yearly, and annually.
What is the maturity date?
The maturity date is the period by which the debenture will mature. At maturity, the debenture issuer returns the capital invested in buying the securities.
What is the difference between convertible and non-convertible debentures?
Convertible debentures have an option in-built, which allows the company to convert the bonds into shares. In contrast, non-convertible debentures will remain a fixed-income instrument throughout history.
Who can invest in debentures?
Individuals, family offices, Hindu Undivided Families (HUFs), companies, banks, primary dealers, and other corporate bodies may invest in debentures, but it will depend on the minimum investment criteria and eligibility provided in the term sheet of the debenture.
What is the credit rating of debenture?
Credit ratings are provided by independent credit rating agencies in the country and denote the creditworthiness of the underlying issuer. The ratings bear the coupon/interest rate offered. For instance, a lower credit rating bond would most likely provide higher interest than a higher-rated bond.
What is a term sheet?
A term sheet is a document associated with debentures that provides all the terms and conditions of the issuance. This will include coupon rate, maturity date, credit rating, type of debenture, and covenants, among other things. A term sheet thus provides all the details required of the debenture to make a qualified investment decision.
Who regulates debentures in India?
The Securities and Exchange Board of India (SEBI) is the regulatory authority for the country’s financial markets, including debentures.
How do I buy debentures?
NCDs are generally issued by a company on the stock exchange and then traded in the secondary market. Hence, you can either subscribe when a company declares NCD or purchase later in the secondary. Market.
Usually, listed enterprises issue NCDs in NSE and BSE, where such instruments are publicly traded. It is important to note that while selecting the best NCD offers, the credit rating of the company, credibility of the issuers, and coupon rate must be checked.
How can I buy debentures online?
Non-convertible debentures/tax-free bonds/Bonds are debt instruments that can be purchased from the secondary market with the help of a trading account. It is similar to buying and selling shares.
