Types of Debentures

Derived from the Latin word ‘debere’ which means to borrow, a debenture is an acknowledgement of a debt that any organisation has taken from entities within an economy. Companies and firms use this financial instrument to raise long-term debt capital. There are numerous debentures types based on the point of view from various particulars such as security, tenure, convertibility, etc.

A debenture issued by an organisation is an official authentication that an organisation has borrowed a certain sum of money from the public. The borrowed sum comes with a promise that the organisation will repay the amount on or before a specified date in the future. So, debenture holders can also be referred to as creditors of an organisation. One key feature that differentiates debentures from other forms of debt is that they lack collateral backing, that is, no capital/asset whatsoever is assured in favour of the debt.

What is the Definition of Debentures?

A debenture is a note of promise of a long term corporate bond, in the finance world, that is usually backed by the reputation and integrity of borrowers and also specific assets of borrowers. The borrower is usually a company or a firm, and the lender is the public. 

In simpler terms, debentures are nothing but another variant of debt instruments that rely primarily on the general creditworthiness of an issuer to raise borrowed capital. Both public and private sector companies issue such a type of corporate bond to secure capital. Just like all other types of bonds, debentures are also documented in an indenture.

A perfect debenture example would be any kind of government-issued treasury bond. Such bonds, known as treasury bills are regarded as risk-free as the government, in the worst-case scenario, can print more money or raise tax rates of the country to pay off its debts. One major advantage of debenture is that it helps startups and unestablished firms to achieve a breakthrough as it protects them from market volatility and recession related damages. With a secured source of long term funding, debenture issuing firms have a chance to flourish. One major disadvantage is that there is no collateral or hold over ownership and owing to its low liquidity, investors hesitate to freely invest, especially for those companies that fail to build mutual investor trust.

Classification of Debentures

There are several kinds of debentures, and they can be categorised according to the following particulars –

• Redemption or Tenure

Under this category, debentures can be subdivided into 2 types:

1. Redeemable Debentures

Such debentures hold a particular date of redemption which is mentioned on the certificate. An organisation is legally entitled to repay the principal amount to their debenture holders before the redemption date. 

2. Irredeemable Debentures

This type of debentures do not carry any specific time of redemption on their repayment terms. For irredeemable debentures, redemption is made possible by the liquidation of the issuing body or as per any agreements between the concerned parties. 

• Convertibility

Based on convertibility, debentures can be further classified as:

1. Convertible Debentures

In the case of such debentures, holders can exercise their right to convert all of their holdings into equity shares. Such debentures can be thereby subdivided further into fully and partially convertible debentures.

1. Fully Convertible debentures: Fully Convertible Debentures (FCDs) is the type of security debt, that involves conversion (convertibility) of its entire value into equity shares as per issuer’s notice. One key feature of FCDs is that unlike other debentures, the issuing firm in this type of debt can “force” conversion of debentures into equity as per their needs. This majorly benefits the issuing company, as it is now free of any market risk as eventually all FCDs will convert to equity . It also helps them reduce short term risks for its investors and helps the company grow. The investors also enjoy conversion benefits as their status is same as that of the company shareholders, post conversion.

On the downside, it poses uncertainty to the investors, as it is more likely to help the shareholders than the investors.It is also important to note that FCD holders will receive no value, in case the issuer/firm goes bankrupt. Also, the holder will be able to redeem the invested funds only after all secured creditors are paid. 

FCDs are important debentures as they help most firms sail through recession. The firm gains well as the company can force conversion and swiftly eliminate any interest payment. In short, FCD holders gain only when and if the company recovers. 

2. Partially convertible debentures: Partially Convertible Debentures (or PCDs) differ from FCDs in that a fraction of the debenture value can be retrieved by the investor in cash as security value, while the rest of the debt is converted to equity.

2. Non-convertible Debentures

For non-convertible debentures, holders do not have the option of converting their holdings into equity shares, and it will always remain as debt for the whole of the tenure.

• Security

From the point of security of the borrowed sum, debentures can be grouped into two parts:

1. Secured Debentures

Such debentures are secured by some asset or set of assets which the holders can liquidate if needed. These debentures can be further classified as first mortgaged and second mortgaged debentures. 

2. Unsecured Debentures

When the debentures are issued solely by leveraging the creditworthiness and goodwill of a company, it is known as unsecured debentures or naked debentures.

• Transferability or Registration

As per transferability and registration, debentures can be subdivided into:

1. Registered Debentures

In the case of registered debentures, the name and address of the debenture holder and information pertinent to holding are registered with the issuing organisation.

2. Unregistered or Bearer Debentures

Such debentures can be transferred easily to a new holder as details of the previous holder are not registered with the issuing company.

• Types of Interest Rate

Debentures can be differentiated according to their type of interest rates, which are:

1. Floating - Rate Debentures

This type of debenture accrues interest at a floating rate for the whole of its tenure.

2. Fixed - Rate Debentures

The interest rate of such debentures is immune to alterations in market rates and remains fixed for the entirety of the holding tenure. 

• Coupon Rate

Depending on the presence of coupon rates, Debentures are classified as follows:

1. Zero - Coupon Rate Debentures

Such debentures do not have a coupon rate which means that holders are not liable to receive any interest payment. 

2. Specific - Coupon Rate Debentures

These are normal debentures which have a specific interest rate.

3. Secured Premium Facility

This kind of debentures offer issuers the facility of redeeming at a premium over the face value of the debentures.

• Mode of Redemption

Debentures are also categorised as per their mode of redemption, which is as follows:

1. Callable

Here, issuing companies and firms possess the rights to redeem the debentures before the tenure is over at a premium to the holder or investor.

2. Puttable

In this case, debenture holders can request the organisation for settling the loan through principal payment. 

3. Subordinated

 These debentures are given higher priority of settlement compared to other debts in case a company is forced to opt for liquidation. 

4. Participating

Such types of debentures are common in the field of venture capital financing. Interest is carried out in three phases where no interest is charged during the initial phase. During the middle phase, a lower rate of interest is charged while in the final phase, the rate of interest applicable is comparatively higher.

If you want to dive into a detailed explanation of the different types of debentures and their examples, make sure to visit the official website of Vedantu.

Advantages and Disadvantages of Debentures

Advantages

1. As most banks are becoming reluctant in offering business loans (especially to startup firms), combined with the heavy obligations they face, it has become increasingly common for company directors to lend their own company and secure debentures that shall eventually shield them from current and future market insecurities.

2. Debentures mature in the long term and help secure long term funding for businesses to establish and grow.

3. Unlike other debt instruments, debentures have a fixed/definite maturity period and a fixed (unchanging) rate of interest during its term, meaning investors receive a fixed amount as agreed upon at the time of issuance of the debenture and in the long term can be a good source of income to sustain oneself financially.

Disadvantages

1. One major demerit of debenture is that there is no hold over ownership even though equity shareholders may be liable to exercise periodic control over its operations (of issuing debentures and/ or forcing conversions). Debenture holders, unlike in other fiscal instruments, have no voting rights to protect their interest in face of market volatility.

2. Another demerit is that debenture interest rates are taxable as per government norms, and investors pay money as taxes while shareholders can avoid them.