Friday, May 17, 2013

Debentures DeMystified


The Term Debentures is used very frequently in the Indian Markets and not many of us are aware of what they are or how they work. The idea of this article is to help us learn more about these debt instruments.

What is a Debenture?

Debentures function more or less like bonds. One can also term debentures as a variant of bonds. Debentures are issued by a company which offers to pay interest in lieu of the money borrowed for a pre-specified period. In essence, it represents a loan taken by the issuer who pays an agreed rate of interest throughout the life of the instrument and repays the principal normally, unless otherwise agreed, on maturity. Bonds on the other hand are more secured than debenture. As a debenture holder, you provide unsecured loan (most of the times debentures are unsecured in nature) to the company. Debentures carry a higher rate of interest as the company does not offer any collateral to you for your money. For this reason bond holders receive a lower rate of interest but are more secure in nature.

Some debentures also offer put and call window, where the issuer can call for repayment or the debenture holder can put for redemption after a certain period but before the maturity date. Debentures are further categorised based on their security and convertibility to equity shares. i.e. the debenture holder has the privilege to convert his status from a lender to an owner in the company.

Based on convertibility, you have the following options to choose from:

Non-Convertible Debentures (NCD): These instruments retain the debt character and cannot be converted into equity shares.

Partly Convertible Debentures (PCD): A part of these instruments are converted into equity shares in the future at notice of the issuer. The issuer decides the ratio for conversion, which is normally decided at the time of offer.

Fully convertible Debentures (FCD): These are fully convertible into equity shares at the issuer's notice. The ratio of conversion is decided by the issuer. Upon conversion the investors enjoy the same status as equity (i.e. ordinary) shareholders of the company.

Optionally Convertible Debentures (OCD): The investor has the option to either convert these debentures into shares at a price decided by the issuer/agreed upon at the time of the offer.

Based on the security offered by the debenture, they are also classified into the following types:

Secured Debentures: These instruments are secured by a charge on the fixed assets of the issuer company. So if the issuer fails on repayment of the principal or interest amount, then the assets of the issuer can be sold to repay the liability towards its lender. However the secured nature of the debenture does not guarantee your principal, but it only gives you the right at par with the other lenders of the company to have a claim on the assets of the
company.

Unsecured Debentures: These debentures unlike the ones mentioned above, aren’t secured against the assets of the company. Thus if an issuer defaults on payment of the interest and (or) the principal amount, then you, as a lender, do not have a claim against the assets of the company, and are exposed to very high risk.

Now, that you are aware of the various types of debentures let us move ahead and understand as to who regulates debt market in India, which will be the topic of our next post!!!

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