- A Comprehensive Guide to Understand Debentures
- What is the meaning of debenture?
- Types of Debentures
- Characteristics of Debentures
- Advantages of Debentures
- Process of Issuing Debentures
- Factors to consider before Investing in Debentures
- Trading Debentures
- Regulatory Framework for Debentures
- Comparison with Other Instruments
- Risks Involved Investing in debenture
- Debenture Investment Strategies
- Debentures in the Indian Context
Companies must have a solid financial backing to stay relevant in today's competitive world. There are different ways to raise capital, and debt financing is among the most sought-after method to raise capital. Debentures are a type of debt financing used by established corporations. It is a popular investment instrument that offers a low-cost source of capital for companies while providing investors with a fixed income stream. The company borrowing funds promises to repay the principal amount and interest to the investor at a specified date in the future. Unlike equity shares, debenture holders do not have any ownership in the company.
What is the meaning of debenture?
Well, debenture originated from the Latin term "debenture", which translates to "they are owing". Understanding debentures is vital for anyone looking to invest in it. In this comprehensive guide, we will discuss debentures, its types and characteristics, the associated advantages and risks, and the regulatory framework governing them.
Types of Debentures
Companies can use different types of debentures to raise capital from investors. Here are some of the most popular ones.
1. Convertible debentures :Convertible debentures allow investors to change it into equity shares of the issuing company at a future date. As a result, these debentures usually offer a lower interest rate than non-convertible debentures. On the other hand, non-convertible debentures cannot be changed into equity shares. Therefore, these debentures provide a relatively higher interest rate than convertible debentures.
2. Secured & unsecured debentures :Assets of the issuing company back secured debentures. In case of default, the assets are sold to repay the debenture holders. Any assets of the issuing company do not back unsecured debentures. Therefore, they are riskier than secured debentures and offer a higher interest rate to compensate for the risk.
3. Redeemable & irredeemable debentures :Redeemable debentures have a specified maturity period and are redeemed by the issuing company on the maturity date. Irredeemable debentures do not have a maturity date and are not redeemed by the issuing company. Instead, they continue to pay interest to the debenture holders indefinitely.
Characteristics of Debentures
Different debentures have varied features and characteristics. Here are some key characteristics of debentures.
Debentures have a specified maturity period, which is the date on which the issuing company must repay the principal amount and interest to the debenture holders.
The coupon rate is the interest rate the issuing company pays on the debentures. It is usually fixed at the time of issuance.
The face value is the value of the debenture at the time of issuance. It is the amount the issuing company promises to repay the debenture holders on the maturity date.
A debenture trustee is appointed to protect the interests of the debenture holders. In addition, the trustee represents the debenture holders in case of any dispute with the issuing company.
Advantages of Debentures
1. Low cost of borrowing funds - The low cost of borrowing funds is a significant advantage offered by debenture to companies compared to other funding sources, such as equity.
2. Non dilute companies - Additionally, debentures do not dilute the company's ownership, as they are a form of debt rather than equity.
3. Tax benefits - Debentures also offer tax benefits to both issuers and investors, making them an attractive investment option.
Process of Issuing Debentures
Preparing a debenture prospectus :Compare the brokerage fees charged by different brokers for different services.
Get the following Document Ready :While low brokerage fees may be appealing, it's important to consider the overall value proposition. A broker that charges slightly higher fees but offers superior research and advisory services, for example, may be a better choice in the long run.
Certified Debenture Certificate:Choose a broker that is transparent about its fees and charges. This means the broker should clearly outline all charges upfront, so there are no surprises later.
Factors to consider before Investing in Debentures
Debenture provides regular income in the form of interest. However, before investing in debentures, investors must consider various factors, including the credit rating of the issuing company, the yield & coupon rate, and current market conditions. A company's credit rating is the most crucial factor to consider as it determines the risk of default. Also, comparing the yield and coupon rates of different debentures will help investors find the best fit.
Debentures are mainly traded in the secondary market, allowing investors to buy and sell them after they have been issued. It is very similar to equity trading buyers and sellers trade debentures at prices determined by market forces. However, debenture trading has several benefits over equity trading, including lower volatility and less exposure to market risk.
Regulatory Framework for Debentures
Several regulations, including SEBI guidelines and provisions of the Companies Act, govern debenture issuance. SEBI guidelines provide a framework for the issuance and trading of debentures, ensuring transparency and investor protection. The Companies Act also sets out rules for the issuance and redemption of debentures, including the requirement to set aside a debenture redemption reserve.
Comparison with Other Instruments
Debentures can be compared with other investment instruments, such as bonds, shares, and mutual funds. Bonds are similar to debentures -they are also a form of debt, but they are typically issued by government entities or large corporations. On the other hand, shares represent ownership in a company and are not a type of debt instrument. Mutual funds are a collection of investments, including both debt and equity. These are managed by professional fund managers.
Risks Involved Investing in debenture
Investing in debentures involves several risks, including credit, interest rate, inflation, and liquidity risks. Credit risk refers to the risk of default by the issuing company, while interest rate risk is the risk that changes in interest rates will affect the value of the debenture. Inflation risk refers to the risk that inflation will erode the value of the investment over time, while liquidity risk is the risk that the investor will not be able to sell the debenture when needed.
Debenture Investment Strategies
Debenture investment strategies help investors to manage their investment risk and achieve their financial goals. There are different strategies used by investors, including ladder and barbell strategies. The ladder strategy involves investing in varying maturities, while the barbell strategy involves investing in both short-term and long-term debentures. In addition, many follow a bullet strategy when it comes to debenture investment. This strategy involves investing in debentures with a specific maturity date.
Debentures in the Indian Context
In India, the debenture market has grown significantly over the years. Indian companies issue debentures to raise funds for various purposes such as expansion, modernisation, and working capital requirements. In addition, government policies such as tax benefits for debenture investments have also encouraged the growth of the debenture market in India.
Debentures are a popular investment instrument for both investors and companies. The low cost of borrowing and no equity dilution makes it an excellent choice for companies needing funds. In addition, there are other benefits, including tax concession and flexibility in issues, which makes it a great choice. However, investors must consider factors such as credit rating, yield, and market conditions before investing in debentures.