What are Debentures: Meaning, Difference and Features

When a company needs funds for expansion, purchasing machinery, launching new ventures, or meeting working-capital requirements, it can raise money through various sources, including borrowing from investors.

A debenture is a debt instrument issued by a company to raise funds from investors. It represents the company’s borrowing and includes a commitment to pay interest and repay the principal amount at a specified time. Debentures are therefore an important source of long-term financing for companies.

This article explains what debentures are, their features, and more.

Key Takeaways

• Companies use these debt instruments to raise funds from investors.
• Investors become creditors rather than owners and typically receive regular interest.
• They may be secured or unsecured and can be either convertible or non-convertible.
• Unlike shares and other bonds, they differ in ownership, repayment, security, and contractual terms.
• While they can offer regular income, investors should assess the issuer’s financial strength and the risks involved.

What is a Debenture?

A debenture is a long-term debt instrument that a company issues to raise capital from investors; upon purchase, it makes the buyer a debenture holder. This instrument obliges the issuing company to pay the buyer a specified interest rate.

For example, if a company needs ₹10 crore to expand its manufacturing unit, it can issue ₹10 crore in debentures to investors instead of taking a bank loan.

If the debentures pay 8% interest, the company must pay that interest to debenture holders.

In addition, the issuing company must repay the principal amount to debenture holders at the end of the maturity period.

Unlike shareholders who purchase the company’s stock, debenture holders are creditors and, as such, do not have voting rights at the shareholders’ meeting.

Key Features of Debentures

Debentures possess various characteristics which distinguish them from shares and other financial instruments. Some major characteristics of debentures are discussed below:

• Debentures are a Form of Debt: The most significant characteristic of debentures is that they are a form of debt. When an investor purchases debentures, they lend money to the company. The company must repay the amount lent by the debenture holder.
• Fixed Rate of Interest: Like bonds, debentures usually carry a fixed rate of interest known as the coupon rate. This means the debenture holder knows how much interest they will receive. For instance, they will get ₹10,000 as annual interest on an investment of ₹1,00,000 at a rate of 10%. Debenture holders expect to receive interest on their investment regularly, as per the terms and conditions of the debentures.
• Fixed Period: Debentures typically have a fixed maturity period. The maturity period can vary depending on the requirements of the company and the terms and conditions of the debentures. The company has to pay off the entire amount of debentures to the debenture holders upon expiry of the maturity period.
• Debenture Holders are Creditors: Debenture holders are creditors to the company. This is because debenture holders buy debentures to earn returns by lending money to the company. In this respect, debenture holders are different from shareholders. Shareholders buy shares to become owners of the company, while debenture holders do not.
• No Ownership Rights: Debenture holders are like lenders or creditors to the company. They have no ownership rights in the company. Debenture holders usually do not have voting power and therefore do not participate in the company's decision-making process.
• Priority in Repayments: Debenture holders have a claim over the company's assets. In the event of liquidation, debenture holders are paid before shareholders. In other words, the debenture holders are preferred creditors. This preference comes with certain risks, depending on the type of debentures held.

Types of Debentures

1. Secured and Unsecured Debentures:
   • Secured debentures are backed by the company's assets. They provide security to investors.
   • Unsecured debentures are not backed by any assets of the company. Payment of such debentures depends on the company's creditworthiness.
2. Convertible and Non-Convertible Debentures:
   • Convertible debentures can be converted into equity shares of the company at a specific time decided at the time of issuing the debentures.
   • Non-Convertible Debentures (NCDs) cannot be converted into equity shares. They remain as debt instruments until their maturity.
3. Redeemable and Perpetual Debentures:
   • Redeemable debentures are redeemed or repaid after a certain period of time.
   • Perpetual debentures have no specific redemption period. They may expire on a specific event or as per the terms and conditions mentioned in the prospectus.

4. Partly Convertible Debentures (PCDs):

   These are debentures where a specified portion can be converted into equity shares at a predetermined price after a set period.

5. Fully Convertible Debentures (FCDs):

   These instruments are entirely converted into equity shares of the company upon the expiry of a specified time, as per pre-determined terms.

Advantages of Debentures

• Stable and Regular Income: Debentures provide investors with a dependable income stream through fixed interest payments, regardless of market volatility.
• Higher Repayment Priority: Debenture holders enjoy priority over equity and preference shareholders in the recovery of principal and unpaid interest if the company faces financial distress or liquidation.
• Capital Appreciation Potential: Convertible debentures offer the opportunity to convert debt into equity shares, allowing investors to benefit if the company's stock price rises.
• Capital Preservation: As fixed-income instruments backed by company assets or promises to repay, they generally present lower capital risk compared to direct equity investments.
• Flexible Investment Choices: Investors can choose from various structures—such as secured, unsecured, or convertible options—to match their specific risk tolerance and return objectives.

Limitations of Debentures

• Interest Rate Risk: Changes in broader market interest rates can cause the market value of existing debentures to fluctuate, leading to potential capital losses if sold before maturity.
• Credit and Default Risk: If the issuing company faces severe financial distress or insolvency, investors risk delayed payments or a complete loss of principal and interest.
• Inflation Risk: The fixed interest payouts from debentures can lose purchasing power over time during periods of high inflation.
• Liquidity Risk: Many debentures, especially non-traded or unlisted ones, suffer from low market liquidity, making it difficult to sell them quickly at a fair price when needed.
• Capped Returns: Unlike equity shares, debentures do not participate in the company's excess profits or extraordinary business growth, limiting returns to the fixed interest rate.

Difference Between Debentures, Shares, and Bonds

Basis	Debentures	Shares	Bonds
Meaning	Debentures are debt instruments a company issue to raise capital from investors.	Shares represent ownership in a company and make the holder a part-owner.	Bonds are debt instruments issued by a company, government, or other entities to raise capital.
Nature	It is a form of borrowed capital.	It is a form of owned capital.	It is a form of borrowed capital.
Holder	The debenture holder becomes the creditor of the issuing company.	The shareholder becomes the owner of the issuing company.	The bondholder becomes the creditor of the issuing company.
Return	The debenture holders receive regular or fixed income on their capital.	Depends. If it is an equity share, the shareholder receives dividends; however, the amount is not fixed.	The bondholders receive regular or fixed income on their capital, depending on the type of bond.
Voting Rights	Generally, debenture holders do not have voting rights.	Equity shareholders enjoy voting rights.	Bondholders generally do not have voting rights.
Risk	It depends on the type of debenture. However, overall, it is relatively less risky than equity shares.	The risk is generally high since dividends depend on the company’s profit.	It depends on the type of bonds and the issuing company; however, on average, it is less risky than equity.
Repayment	Repayment is made after the maturity period ends.	Normally, shares are not repaid unless the company buys them back.	Bonds are repaid on their maturity date; however, some bonds allow early redemption.
Security	Can be secured by specific company assets or issued as unsecured instruments.	Not secured, as shares represent equity ownership rather than a debt claim.	Can be secured by collateral/assets or issued as unsecured (debentures are Technically, a type of corporate bond.
Priority in Liquidation	High priority. Debenture holders must be fully paid out before any distribution to shareholders.	Residual claim. Shareholders can only claim remaining assets after all creditors' claims are settled.	High priority; as creditors, bondholders rank ahead of shareholders and must be paid first during liquidation.