A company may raise funds from its holders through debt or Equity Finance. In the beginning stage of establishment, a company may need more time to be ready for Equity finance. Hence, borrowing by way of bonds and debentures is preferable. In this blog, we will study the Debentures – meaning, characteristics, types, benefits, risks and the trend of MLD in the Stock Exchange.W
Debentures meaning
When a company chooses debt financing, it sells fixed-income instruments as Debentures. Debentures are interest-bearing and need to be paid off at the end of their term. Investors who buy debentures enjoy priority in case the company goes bankrupt. These lenders or creditors have a higher claim on any liquid asset owned by the company.
Process of Issuing Debentures
- The process of Issuing debentures is extensively explained in the Companies Act, 2013.
- According to the provisions, a company cannot issue more than 500 debentures unless it appoints a debenture trustee. The appointment of a debenture trustee must be held before the issue of the prospectus of debenture.
- The issuing company must create a DRR (Debenture Redemption Reserve) out of its profits. This is done to protect the interest of the debenture holders.
- The issue of debentures must be filed by way of designated forms with the Registrar of the company.
Characteristics of Debentures
Debentures encompass these key characteristics:
- Redeemable Nature: They are issued for a specified period, on expiry of which, debentures can be redeemed.
- Long-term: Debentures are issued for a period ranging from 5 years to 30 years. These provide funds to companies on a long-term basis.
- Fixed Interest: They carry a fixed rate of interest which is prescribed at the time of issue of debentures.
- Voting Rights: Unlike Shareholders, Debenture holders do not have voting rights to participate in the company’s management.
Different Types of Debentures in India
Debentures are mainly categorised by way of their Security, Tenure, and Convertibility.
- Secured Debentures
Secured debentures as the name suggests are secured against the assets of the company. In case of non-repayment of debentures, holders have the first right over these assets. - Unsecured Debentures
Unsecured debentures are seldom circulated as there is no collateral security. Hence, not more than a few investors would be ready to invest based on the company’s creditworthiness. - Convertible Debentures
Convertible debentures allow investors to change the nature of their investment after a certain period. The holder can opt to convert debentures into equity or other forms of investment. It certainly depends upon the clauses mentioned at the time of issuance. - Non-convertible Debentures
Most of the debentures issued in the market are non-convertible. This means that a debenture holder can not be an equity holder of the company by merely changing the nature of the investment. - Redeemable Debentures
After the tenure, say 5 or 20 years, the company may reclaim the debentures at the par or premium price. These are redeemable debentures. The company may choose to pay the borrowed amount in lump sum or instalments. - Irredeemable Debentures
Irredeemable debentures are also called ‘perpetual debentures’ as they are circulated in the market for a long period. The holders earn timely interest throughout the life of these debentures and are paid off only at the time of winding up of the enterprise.
To safeguard interest of the investors, companies can no longer issue Irredeemable debentures.
Benefits of Investing in Debentures
- Regular income through interest payments
Debenture holders earn regular interest. - Diversification in an investment portfolio
Debt funds provide a balance in the investment portfolio. - Potential for capital appreciation
Convertible debentures allow the holder to be the owner of the company.
Risk Factors
While debentures are fixed-income instruments, they are not risk-free
- Credit risk – The unsecured debentures rely highly on the creditworthiness of the company.
- Interest rate risk – Fixed interest rates may not be attractive if the interest rates on other instruments rise.
- Liquidity risk – Debentures are long-term investments, which means withdrawal of funds during an emergency may not be possible.
Mitigation of Risks
Although one may invest in secured debentures, the risk of the company closing up always lingers around. To reduce this stress investors can follow these 3 steps:
- Evaluate the issuer’s creditworthiness
An issuer’s credit worth can be determined with the help of credit rating agencies, government websites, and financial records of the company. - Monitor interest rate movements
A regular check on the interest rates in the market will allow investors to make informed decisions. - Diversify portfolio
All eggs in one basket is a poor strategy. Investors must analyze their investment goals and choose balancing between equity and debt investment.
Market Trends with Debenture
- Debenture market in India
For over 2 decades, Structured products known as MLD (market-linked debentures) have been traded on stock exchanges.
A minor amount of the face value of these debentures are invested in Index funds which give higher returns as compared to regular interest rates or fixed deposits. - Investing in MLD
In the Union Budget of 2023, the minimum investment in MLD has been lowered to Rs. 1 Lakhs from Rs. 10 Lakhs.
This initiative by the government intends to motivate investors towards MLD.
Investors can buy MLD through their demat accounts. - Risks involved in MLD
In structures where the principle is not secured, capital loss is the highest risk.
The Tenure of MLD might not capture the best upward movement of the Index market.
The credit of the Issuer is a risk at any given point in time.
Despite MLD being listed on stock exchanges, premature withdrawal of funds is not easy.
Since the MLD has been traded only for the past 20 years, it lacks transparency and more marketing colours.
Conclusion
- Debentures are debt instruments issued by the company to raise funds. Investing in debentures means earning regular interest for the long-term period.
- They are classified based on their collateral security, tenure and convertibility.
- A successful investment in debenture relies largely on the creditworthiness of the issuer company. Debentures are not considered liquid funds as the withdrawal before maturity is not easy.
- Investing in MLD is still a new concept for mid-range investors. However, one may experiment with a minimum amount of Rs. 1 lakh all the while balancing the rest of the portfolio with equity and Fixed Deposits.