This article explains how debentures work, along with their key features, types, advantages, limitations and risks.
Table of Contents
Why do companies issue debentures?
Companies issue debentures to access long-term capital without diluting ownership.
When investors purchase a debenture, they are essentially lending money to the issuing company for a specified period in exchange for interest payments. However, unlike equity shares, debentures do not offer ownership rights in the company to investors. Instead, investors receive interest income and repayment of principal at maturity, subject to the issuer’s financial ability to honour obligations.
For investors, debentures may offer relatively predictable income compared to equities; however, they carry credit risk, interest rate risk, and liquidity risk.
Read Also: Debt Market: Meaning, Benefits, Types and How it Works?
How do debentures work?
Debentures work like a loan taken by a company from investors. The company raises money by issuing debentures, and in return, it agrees to pay interest and repay the principal amount as per the stated terms. Here’s a general overview of the process of issuing and buying debentures:
- A company first decides how much money it wants to raise and issues debentures to investors. The issue document usually mentions details such as the face value, interest rate, maturity period, and repayment terms.
- Investors who buy the debentures are lending money to the company. They do not become owners of the company, but they become creditors.
- The company pays interest to debenture holders at the agreed rate. This may be paid monthly, quarterly, half-yearly, annually, or as mentioned in the debenture terms.
- At the end of the maturity period, the company repays the principal amount to the debenture holders. In some cases, debentures may be redeemed earlier if the terms allow it.
Example of a debenture
Suppose a company issues debentures worth ₹1,000 each with an annual interest rate of 8% and a maturity period of 5 years. If an investor buys one debenture, they lend ₹1,000 to the company.
The company will pay interest of ₹80 every year, as per the terms of the issue. At the end of 5 years, the company will repay the principal amount of ₹1,000, provided there is no default and the debenture is held till maturity.
This example shows how a debenture works like a debt instrument. The investor earns interest, while the company gets funds for its business needs without giving ownership rights to the investor.
Example for illustrative purpose only
How is a debenture different from a bond?
Debentures fall under the broader category of bonds. However, they differ from other bonds in some ways.
| Criteria | Debenture | Bond |
| Meaning | A debenture is a debt instrument generally issued by a company to raise funds from investors. | A bond is a broader debt instrument that may be issued by governments, companies, or other institutions. |
| Issuer | Usually issued by companies or corporate entities. | May be issued by governments, municipalities, public sector entities, or companies. |
| Common usage in India | The term is commonly used for corporate debt instruments, such as non-convertible debentures. | The term is used more broadly and may include government bonds, corporate bonds, and other debt securities. |
| Overall idea | A debenture is often understood as a company-issued debt instrument. | A bond is a broader term for debt securities issued by different entities. |
Features of debentures
Debentures carry specific contractual terms that determine income payments, repayment conditions, and investor rights. Understanding these features may help investors evaluate the risk-return characteristics associated with debenture investments.
Key features of debentures in simple words include:
- Fixed or predefined interest payment: Debentures generally offer a stated interest rate, known as the coupon rate, which is paid periodically as per issue terms.
- Defined maturity period: Every debenture has a specified tenure at the end of which the principal amount is repaid to investors, subject to issuer repayment capability.
- Secured or unsecured structure: Some debentures are backed by company assets, while others rely only on the issuer’s credit strength.
- Credit rating: Credit rating agencies assess the issuer’s repayment capacity. Ratings indicate relative credit risk but do not eliminate default risk.
- Tradability: Many debentures, especially listed Non Convertible Debentures (NCDs), may be bought or sold on stock exchanges, depending on market liquidity.
- Convertibility option: Certain debentures may be convertible into equity shares after a defined period, while others remain pure debt instruments.
- Priority in repayment: In case of liquidation, debenture holders generally receive repayment before equity shareholders.
- Regular income structure: Interest payouts may occur annually, semi annually, quarterly, or cumulatively depending on issue terms.
Types of debentures
Debentures may be classified based on security, convertibility, and repayment structure. Each type carries different risk characteristics, income structures, and investment considerations.
Secured debentures
These are backed by company assets. If the issuer fails to meet its repayment obligations, the asset may be sold to repay investors. This structure may entail lower risk on invested capital than unsecured options.
Unsecured debentures
These are not supported by specific assets. Repayment depends on the issuer’s financial health and credit rating. They generally carry a higher risk compared to secured instruments.
Convertible debentures
Convertible debentures may be converted into company equity shares after a defined period and at a predetermined conversion ratio. They may be suitable for investors seeking potential capital appreciation opportunities over time if the company’s share price increases. However, conversion exposes investors to equity market risks, including potential capital loss if share prices decline.
Non-convertible debentures (NCDs)
NCDs cannot be converted into equity shares. Investors receive periodic interest payments and repayment at maturity. Listed NCDs may be traded on stock exchanges, depending on liquidity and demand.
Redeemable debentures
These are repaid at or before maturity, based on the company’s terms of issue.
Irredeemable or perpetual debentures
These do not have a fixed maturity date and may remain outstanding indefinitely until the company decides to repay or is liquidated. Such instruments are rare in the Indian market.
Read Also: What are fixed income securities? Types and Features
Difference between a debenture and a loan
Both debentures and loans are borrowing mechanisms used by companies to raise funds. However, they differ in structure, investor participation, transferability, and regulatory framework.
| Debenture | Loan | |
| Source Of Funds | Issued by companies to raise funds from multiple investors through public issue or private placement | Borrowed from banks or financial institutions |
| Number Of Lenders | Involves a large number of investors subscribing to the issue | Usually involves one or a limited number of lenders |
| Tradability | Listed debentures such as Non Convertible Debentures (NCDs) may be traded on stock exchanges depending on liquidity | Generally not tradable in secondary markets |
| Documentation And Structure | Governed by an offer document with uniform terms for all investors | Governed by bilateral agreements negotiated between borrower and lender |
| Interest Structure | Carries predefined interest terms applicable to all debenture holders | Interest terms may vary based on lender negotiations |
| Security Backing | May be secured or unsecured depending on issue structure | May also be secured or unsecured based on loan agreement |
| Regulatory Oversight | Regulated by SEBI for issuance and disclosure requirements | Primarily regulated under banking norms supervised by the Reserve Bank of India |
| Investor Participation | Retail and institutional investors may participate | Typically restricted to banks and financial institutions |
Difference between debentures and shares
When an investor buys shares, they become a part-owner of the company. When an investor purchases a debenture, they lend money to the company and become a creditor rather than an owner. Here are the key differences:
Nature
- Debentures: A debt instrument.
- Shares: An ownership instrument.
Investor’s status
- Debentures: The investor is a creditor of the company.
- Shares: The investor is a shareholder and part-owner of the company.
Returns
- Debentures: Interest is paid according to the terms of the debenture, subject to the issuer meeting its obligations.
- Shares: Returns depend on factors such as dividends, if declared, and changes in the market value of the shares.
Repayment
- Debentures: The principal is generally repaid on maturity, subject to the terms of the issue.
- Shares: Shares generally do not have a maturity date and remain invested until sold.
Voting rights
- Debentures: Debenture holders generally do not have voting rights in company decisions.
- Shares: Equity shareholders generally have voting rights, subject to applicable laws and company rules.
Risk
- Debentures: Risk depends on factors such as the issuer’s creditworthiness, the security structure and interest-rate movements.
- Shares: Share prices are influenced by market conditions and company performance and may experience greater price volatility.
Advantages of debentures
Debentures may serve as an income-oriented investment option for investors seeking exposure to fixed income securities. Their structure offers certain features that differentiate them from equity instruments.
- Companies may raise funds without diluting ownership.
- The issuer may choose repayment schedules and interest payment frequency based on financing needs.
- Regular repayment and timely servicing of interest may help a company build a relatively stronger credit record.
- Investors may receive regular interest payouts, subject to issuer performance.
- Higher-risk debentures may offer higher potential interest rates as compensation.
- Convertible debentures may offer potential equity conversion benefits after a specified period.
Disadvantages of debentures
While debentures may provide structured income features, they also carry certain limitations and risks that investors may evaluate carefully before investing.
- Fixed-rate debentures may lose value if market interest rates rise.
- Credit risk remains, especially with lower-rated issuers.
- Inflation may reduce the real value of interest income.
What are the risks of investing in debentures?
Debentures are market-linked debt instruments and carry multiple risks that investors may evaluate carefully before investing. Since repayment depends on the issuing company’s financial position and prevailing market conditions. Some of the risks are:
- Credit risk: The issuer may default on interest or principal payments.
- Interest rate risk: A rise in market interest rates may reduce the market value of existing debentures.
- Liquidity risk: Certain debentures may have limited buyers or sellers, making early exit difficult.
- Business and market risk: Economic or business challenges may affect the company’s ability to repay.
- Regulatory and taxation risk: Changes in taxation or disclosure regulations may affect post-tax returns.
Read Also: Banking and PSU Funds – Features & How They Work
What is a debenture stock?
Debenture stock refers to pooled or consolidated debentures issued by a company. Instead of holding individual certificates, investors may own a portion of this collective debt. This stock also represents borrowing by the company and may pay periodic interest.
How to invest in debentures in India
Investors in India can invest in debentures through different routes, depending on whether the debenture is newly issued or already listed in the market.
- Through public issues of NCDs: Companies may raise money by issuing non-convertible debentures to the public. Investors can apply for these issues during the subscription period, similar to other public market offerings.
- Through the secondary market: Listed debentures may be bought and sold on stock exchanges. However, liquidity can vary. Some debentures may have active trading, while others may be difficult to sell before maturity.
- Through brokers or bond platforms: Investors may also access debentures through registered brokers or online bond platforms. It is important to check whether the platform is regulated and whether all charges and risks are clearly disclosed.
- Through debt mutual funds: Investors who do not want to buy debentures directly may get exposure through debt mutual funds that invest in corporate debt securities. In this route, the fund manager selects the securities, and investors hold units of the mutual fund.
Taxation of debentures
The taxation of debentures depends on the type of income earned and the way the investment is held.
- Interest income: Interest earned from debentures is generally taxable as per the investor’s applicable income tax slab. It is usually treated as income from other sources.
- Capital gains on sale: If listed debentures are sold before maturity, the investor may make a capital gain or loss.
Gains on listed debentures held for up to 12 months are generally treated as short-term capital gains and taxed as per the investor’s applicable slab rate.
If held for more than 12 months, they are generally treated as long-term capital gains and taxed at 12.5% without indexation, subject to applicable tax rules.
- Tax rules may differ: Tax treatment can vary for listed, unlisted, secured, unsecured, convertible, and non-convertible debentures. Investors may consult a tax advisor for advice based on their individual situation.
Investors should check the applicable tax rules at the time of investment, as tax treatment may change from time to time
FAQs
What are debentures used for?
Debentures are used by companies to raise long-term capital from investors without issuing equity shares. Funds raised may be utilised for expansion, refinancing existing debt, infrastructure investment, or working capital requirements. Investors receive interest payments and repayment at maturity, subject to issuer credit quality and market-related risks.
What are bonds and debentures?
Bonds and debentures are fixed-income debt instruments used to raise funds from investors. In India, the terms ‘’ and ‘debentures’ are interchangeably used and the Companies Act identifies both as the same. Bonds are typically issued by governments or large institutions and are generally secured by assets. Debentures are generally corporate borrowings that may be secured or unsecured.
Are debentures assets or liabilities?
Debentures are liabilities for the issuing company because they represent borrowed funds requiring repayment with interest. For investors, debentures are financial assets forming part of an investment portfolio. Their value may fluctuate based on credit ratings, interest rate changes, and market demand, indicating potential risks alongside income potential.
What do 12% debentures mean?
A 12% debenture indicates that the issuer promises to pay interest at 12% per year on the face value of the debenture. For example, a ₹1,000 debenture pays ₹120 interest annually. However, 12% is not necessarily the investor’s actual return. The yield may differ if the debenture is bought or sold above or below its face value. A higher coupon may also indicate greater credit risk, so factors such as the issuer’s credit rating, security, tenure and repayment terms should be considered.
Example for illustrative purposes only.
How to buy debentures?
Investors in India may buy debentures through primary issuances such as public issues or private placements, and through secondary market trading on recognised stock exchanges. Investments require a demat account and trading account. Investors may review credit ratings, issuer disclosures, liquidity conditions, and risk factors before investing decisions.
Are debentures good or bad?
Debentures are neither inherently positive nor negative investments. They may be suitable for investors seeking periodic income alongside diversification, depending on risk appetite and financial goals. However, debentures carry credit risk, interest rate risk, and liquidity risk, and investors may evaluate issuer quality and portfolio allocation carefully.
Is a debenture a loan?
A debenture is a type of borrowing, but it is not the same as a conventional loan. With a loan, a company typically borrows money from a bank or another lender. With a debenture, it raises money from investors by issuing a debt instrument. In both cases, the borrower is generally required to pay interest and repay the principal according to the agreed terms.
Can debentures be traded in the market?
Yes, listed debentures can be traded on recognised stock exchanges, allowing investors to buy or sell them before maturity, subject to market liquidity and demand. Unlisted debentures are generally not traded on exchanges.
What happens if a company defaults on its debentures?
If a company defaults on interest or principal payments, debenture holders may face delays or losses depending on the issuer’s financial position and the debenture terms. Secured debenture holders may have a claim on pledged assets, while unsecured debenture holders rank behind them. Recovery depends on the applicable legal and insolvency process.
How is debenture interest taxed?
Interest earned on debentures is taxable as “Income from Other Sources” and is taxed according to the investor’s applicable income tax slab. If debentures are sold before maturity, any capital gains may also be taxable based on the holding period and prevailing income tax provisions.
The tax information in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.
