Debentures are debt instruments that are issued by companies to raise funds for the long term, debenture holders are creditors of the company as a company has to repay debentures as and when they fall due, besides company also pay fixed periodic interest to debenture holders for the fund raised from them. Given below are some of the frequently asked questions regarding debentures –
Debentures Questions
Difference between Debenture and Bond
Bond is a debt instrument that is backed by collateral or high-quality security and hence they are less risky while as far as debentures are concerned they may or may not be backed by any collateral and hence they are riskier. Besides in case of liquidation of the company bondholders have a priority right over debenture holders. As far as the interest rate is concerned it is higher in case of debentures when one compares it with the rate of interest on bonds.
Advantages of Debentures
The biggest advantage of debenture is that since they are part of long term liabilities there is no risk of any dilution which is the case with other modes of long term finance like equity share capital besides they carry no voting rights which again is a positive as debenture holders do not interfere with day to day working of the company. Another benefit of this instrument is that they carry a fixed rate of interest and hence company can take benefit of leverage as no matter what the profits of the company are the debenture holders will get fixed rate of interest which is not the case with equity shareholders who get dividend as a percentage of profits.
Disadvantages of Debentures
The biggest disadvantage of debentures is that they carry a fixed rate of interest which has to be paid by the company even when the company is making losses, hence in a way in times of stress it puts an additional burden on the company, another problem with debentures is that since they are secured loans it limits the borrowing capacity of the company as the company cannot use those assets for further borrowing. As far as investors of debentures are concerned they too are at a disadvantage in the sense that they have no voting rights and also their return in fixed which can be frustrating when the company is making bumper profits.
Types of Debentures
Debentures are of many types, first is fully convertible debenture which after a certain period of time can be converted into equity shares in agreed ratio as per initial terms of issue, second is non-convertible debentures which the name suggests are those which cannot be converted into equity shares rather they are simple debentures. Third are redeemable debentures that carry a fixed date of redemption while other is perpetual debentures that are not redeemed on any particular date rather they are redeemed either on liquidation of the company or whenever the company decides to do so.
Other two types are secured debentures which as the name suggests are secured over the assets of the company while other is unsecured debenture which is not secured and hence in case of default by the company the debenture holders have no security and that is the reason why they carry a higher rate of interest as compared to secured debentures. Fixed and floating are other two variants of debentures where fixed debentures carry fixed interest rates over the life of the debenture whereas floating debenture interest rate is benchmarked to some other benchmark rate which can be bank rate, London interbank offer rate or any other rate and hence it keeps fluctuating.
Who can Issue Debentures
Debentures can be issued by companies both private as well as public limited companies, the government can also issue debentures to the general public, however individuals, sole proprietorship or partnership are not allowed to issue debentures.
Difference between Debentures and Stocks
Stocks give holder ownership control as equity shareholders are owners of the company while debenture are long term liabilities and debenture holders are creditors of the company. Another difference between the two is that while stocks are entitled to dividends in case of profits while debentures are entitled to interest whether the company earns a profit or not. Besides stocks have voting rights which is not the case with debentures, also shares cannot be converted into debentures, however, convertible debentures after a specified period of time can be converted into stocks.
Features of Debentures
First and foremost feature of debenture is that they are long term source of finance in the sense that company issues debentures with a maturity period of not 1 or 2 years but between 5 to 20 years, another characteristic of debenture is that in case of any liquidation of the company debenture holders have priority claim over preference shareholder as well as equity shareholders on the assets of the company. Fixed interest rate is another important feature of this instrument apart from it having no voting rights as its holders are creditors of the company and not the owners of the company.
Debentures Assets or Liabilities
Another question that is asked by many people having limited knowledge of accountancy is whether debentures are assets or liabilities, well the answer is simple that it is a long term liability and not a current liability and they appear under secured loan head of the balance sheet of the company.
Difference between Callable and Puttable Debentures
Call options refers to those options in which an individual gets right to buy underlying at a specific price no matter what the current market price is but there is no obligation to buy the underlying as far as debentures are concerned if the company issues callable debentures than it implies that company can redeem the debentures anytime before the maturity of debentures which company will do when the rate of interest are declining as the company can issue new debentures at a lower rate of interest while in case of put options an individual gets right to sell the underlying at a specific price no matter what the current market price is but there is no obligation to sell the underlying as far as debentures are concerned if the company issues puttable debentures than investors can ask for the redemption of debentures from the company anytime they want and the company will have to pay them.
Risks of Debentures
Some of the risks to which debenture holders are exposed are interest rate risk because when a company comes under financial stress they may delay the interest payment of debentures or in times of economic growth interest on debenture becomes unattractive due to other growth opportunities in equity and real estate market. Another risk is default risk especially in case of unsecured debentures as no matter how good credit rating of the company is the risk of default will always be there especially during times of recession.