A Debenture is a debt security issued by a company that offers to pay interest instead of the money borrowed for a specific period. In essence, it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal typically, unless otherwise agreed, on maturity.
Debentures are long-term debt instruments issued by private sector companies. These are issued in varying denominations like Rs 1,000, Rs 10,000, Rs 1Lakh, or even higher. The maturity period of the debentures could be from one year to ten years and, in some cases, even longer. However, long maturity debentures are rarely issued, as investors are uncomfortable with such maturities.
Debentures enable investors to reap the dual benefits of good corporate credibility and high returns. Debentures earlier were issued in physical form. However, with the dematerialization of securities, issuers like Corporates and Public Sector Units (PSUs) have been issuing debentures in Demat form.
Debentures could be classified based on Convertibility and Security.
Debentures based on Convertibility
Non-Convertible Debentures (NCD)
This type of Security retains all the characteristics of debt instruments and cannot be converted into any other form of Security, e.g., in equity.
Partly Convertible Debentures (PCD)
A part of this instrument can be converted into equity shares in the future by the issuer. The issuer decides the ratio of the conversion at the time of subscription.
Fully Convertible Debentures (FCD)
These instruments are fully convertible into Equity shares at the issuer’s notice. The issuer decides the ratio of conversion. Upon conversion, the investors enjoy the same rights as ordinary shareholders of the company.
Optionally Convertible Debentures (OCD)
The investor can convert these debentures into shares at a price decided by the issuer or agreed upon at the time of issue. However, as the name suggests, Convertibility is at the option of the debenture holder. They may choose to get their holdings converted into equity shares or continue holding them in the form of debentures. Debenture holders take this decision depending on the environment in the capital market, company performance, etc.
Debentures based on Security
These debenture instruments are secured by a charge on the fixed assets of the issuing company. If the issuing company fails to pay the principal or interest amount, company assets could be sold to repay the liability to the investors. This is usually in the form of a first mortgage or charge on the company’s fixed assets on a pari passu basis with other first charge holders like financial institutions, etc.
Sometimes, the charge can also be a second charge instead of a first charge. But, most of the time, the charge is created on behalf of the entire pool of debenture holders by a trustee appointed explicitly for the purpose.
These instruments are unsecured in the sense that if the issuer defaults on payment of the interest or principal amount, the investor has no right to the assets of the company, and the amount owed to these debenture holders would be settled after the payment of secured debt securities like dues to employees, government, bonds, etc. However, their claim on the residual assets is before both preference and common shareholders.
Unsecured debentures carry a higher interest rate than secured debentures and other fixed income instruments issued by a company. Higher interest rates attract investors to subscribe the unsecured debentures. Unsecured debentures issued by companies having a proven track record of sound financial performance and credit rating could be considered for investment. Nonetheless, unsecured debentures carry a credit risk.
Understand the Risks in Debentures
To understand the risks, you should read the prospectus to determine how the company will use your funds. For example, it might use your money to finance a wide range of investment activities or may on-lend your money to another business. The riskier the activity, the more careful you should be. See more information on reading a prospectus.
- It is essential that you: understand the return being offered and whether it will compensate for the risks,
- You should understand how the risks of investing in debentures compare with other investments paying interest.
- It would be best if you had diversified your investments.
- You may see professional investment advice if you are unsure of any aspects of the investment.
Bottomline: Debentures Could be Risky Investments; check the Fundamentals
If something goes wrong with your debenture, secured, or unsecured note, you may be able to recover some of your money. Contact the company first with a formal complaint. If you don’t get a satisfactory outcome, you may need to file a complaint with the capital market regulator under the investor grievance department. Check their website for details, e.g., the website of SEBI in India.
While secured and unsecured debentures may seem very attractive, you could quickly lose everything if the company or project fails. So seek financial advice before you invest in one of these products.