Debentures Explained: Meaning, Types & Benefits

Among the various ways businesses may raise capital, debentures are a widely used debt instrument in India. Companies issue debentures to fund expansion, manage daily operations, or finance new projects. Instead of borrowing from banks, they borrow from investors by issuing debentures. In return, the company agrees to pay periodic interest and repay the principal amount as per the issue terms.

Unlike shares, debentures do not provide voting rights or ownership in the company, making them suitable for businesses looking to raise funds without diluting control. For investors, they may offer the potential for regular income through interest payments, depending on the issuer’s performance and financial stability.

In this article, we explore what debentures are, their key features, types, advantages, limitations, and risks.

Table of contents

• What is a debenture?
• Features of debentures
• Types of debentures
• Difference between a debenture and a loan
• Advantages of debentures
• Disadvantages of debentures
• What are the risk factors while investing in debentures?
• Debenture stock

What is a debenture?

The word ‘debenture’ originates from the Latin term debentur, meaning ‘to owe’. A debenture represents a written acknowledgment of debt issued by a company when it borrows money from investors.

A debenture certificate serves as an agreement between the company (borrower) and investors (lenders). It specifies the repayment schedule, interest rate, and maturity terms. Debentures may be secured or unsecured. Secured debentures are backed by specific company assets, while unsecured ones rely on the issuer’s creditworthiness and reputation.

In simple terms, a debenture works like a loan that a company takes from multiple investors instead of a single bank. However, it does not confer ownership; it establishes a creditor-borrower relationship. Debentures may be suitable for investors seeking the potential for regular interest income. However, they carry specific risks including credit risk (possibility of issuer default), interest rate risk (price fluctuations when market rates change), and liquidity risk (difficulty in selling before maturity). Investors should assess these risks in relation to their financial goals before investing.

Read Also: Debt Market: Meaning, Benefits, Types and How it Works?

Features of debentures

Interest rate

The company issuing the debenture decides the interest rate, which may be fixed or floating. A fixed rate remains unchanged during the tenure, while a floating rate is linked to a benchmark. Common floating-rate benchmarks in India include the RBI’s repo rate or Government Security (G-Sec) yields, among others, and are chosen based on the type and tenor of the instrument.

Credit rating

Credit rating agencies such as CRISIL, ICRA, CARE Ratings, and India Ratings assess a company’s repayment capacity. Higher-rated debentures indicate lower credit risk, while lower-rated ones carry relatively higher default risk. However, investors must note that ratings are indicators of relative credit risk, not guarantees of repayment. They can also change over time based on economic conditions and company performance.

Maturity date

The maturity date is when the issuer repays the principal amount. Companies may repay debentures in a lump sum at maturity or periodically through a redemption reserve. For non-convertible debentures (NCDs), the maturity date is an important consideration for both liquidity and income planning.

Types of debentures

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

• Borrowing source: Debentures are issued to multiple investors, while loans are taken from banks or financial institutions.
• Tradability: Debentures may be listed and traded on debt markets, while loans are not tradable.
• Security: Loans often require collateral; debentures may be secured or unsecured.
• Documentation: Debentures follow formal issuance processes and regulatory filings; loans involve private agreements.
• Interest terms: Debenture interest rates are publicly disclosed at issue, while loan rates are negotiated privately.

Advantages of debentures

• 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

• 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 risk factors while investing in debentures?

• 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

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.

FAQs

What is a debenture?

A debenture is a debt instrument issued by a company to raise money from investors. Investors lend funds to the company and receive potential interest income in return.

How do debentures differ from loans?

A loan usually comes from a bank or financial institution, while a debenture is offered to multiple investors and may be traded on exchanges. Debentures may or may not be backed by security.

What are the types of debentures?

Common types include secured, unsecured, convertible, non-convertible, redeemable, and perpetual debentures.

What are the risks associated with investing in debentures?

Debentures may carry credit, interest rate, liquidity, market, and regulatory risks. Investors should evaluate these carefully before investing.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed.The tax information (if any) 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.