What Are Debentures? Meaning, Features, Types And More

Companies don't always go knocking on banks' doors when they need money. At other times, they will make their way to the market, and in offering something called debentures, a type of debt that appeared uncomplicated on the surface but had its own complexity under the hood.

So, for the everyday investor, or even someone experienced chasing predictable returns, knowing the ins and outs of a debenture can translate the difference between a smart fixed-income play or a capital trap.

Ultimately, a debenture is a corporate bond or other long-term debt instrument issued as a promise to repay the principal along with interest. While loans are typically one-to-one transactions with banks, debentures are publicly issued instruments and can be traded in the secondary market, which makes them more liquid but also more vulnerable to interest-rate and issuer risk.

Loans Vs Debentures

Both are debt instruments, but they are part of different systems. Loans are originated by lenders, and are non-negotiable in the secondary market. They tend to have covenants that are more strict and are secured by collateral. Debentures, meanwhile, are largely based on reputation –unless they are secured. This dependency on investor perception is what makes debentures special, and unfortunately, susceptible. At their heart, they're a plea for public trust, backed with guaranteed interest.

For investors considering fixed income, debentures can look appealing due to their yield profile. Abhishek Kumar, a SEBI registered RIA, says, "Debentures could offer higher yields which could be better than FDs and in line with debt MF returns but carry single-issuer default risk and liquidity risks unlike diversified debt MF."

In practice, here's what it means: Let's say XYZ Ltd wants Rs 1 crore to expand its plant. Instead of borrowing, it raises 1,000 debentures of Rs 10,000 each, bearing 8 per cent interest p.a. for 5 years. Investors buying in will receive Rs 800 every year per unit held, and their principal back after five years. No ownership, no boardroom voice, just a fixed income.

Where Do Debentures Fit in an Investor's Portfolio?

Kumar also outlines their role in portfolio construction: "Based on an investor's risk appetite, investment-grade debentures can at best work as a 'satellite' allocation of 5-15 per cent within the fixed income portfolio but one should avoid it as part of core fixed income portfolio such as debt MFs or FDs."

What Are Different Types Of Debentures?

All debentures are not equal. Here's how they break down:

Convertible Debentures:

These begin with obligations to repay debt but can be converted into equity shares after a fixed period. For companies at this stage, this provides them flexibility to raise money now, and then, perhaps, convert that debt to equity at a later date. These are the kinds of indicators that investors have their eye on when placing bets on a company's future. The downside? Interest rates tend to be lower than those of non-convertibles.

Non-Convertible Debentures (NCDs):

Pure debt, no conversion. Investors get fixed returns and principal at maturity. These instruments often appeal to conservative portfolios. In the event of a company collapse, the payback hierarchy becomes crucial.

Secured Debentures:

Backed by company assets. If the issuer defaults, the investor has a claim on specified collateral. These may come with lower risk and are attractive to those who fear unsecured corporate paper.

Unsecured (Naked) Debentures:

Issued without backing. High-risk, especially if the issuer has a checkered credit history. Investors depend solely upon the creditworthiness of the firm.

Redeemable Debentures:

These have a set maturity date. They are redeemable, in full or in part, after a certain period.

Irredeemable (Perpetual) Debentures:

These have no maturity date. Because of SEBI limitations, it is rarely issued in India. They offer regular interest, but no guarantee of principal return, making them riskier and less popular in retail investment circles.

Key Characteristics Of Debentures

Fixed Liabilities: Even without profit, the company's interest has to be paid. It's a binding financial duty.

Tradable: Unlike loans, which are generally held to maturity, many debentures can be purchased and sold on exchanges, providing investors with an exit.

Maturity Terms: When and how the principal will be repaid? What the Issuers Say? That rate is either at par, at a premium or at a discount.

No Voting Rights: Debenture holders have no say in company matters. They're creditors, not stakeholders.

Precedence in Liquidation: In case the company turns sick, the debenture-holders are placed above the shareholders in the line of claim.

As for evaluation, Kumar explains the due diligence process: "One should check the credit ratings (prefer AA-/AAA from multiple agencies), study the offer documents for collateral details, analyze issuer financials (interest coverage, leverage, cash flows), compare coupon rates to peers, and limit single-issuer exposure to 5 per cent of portfolio to manage concentration risk."

Possible Risks

Credit Risk:

If the company defaults, the whole investment is at stake. Lower-rated debentures may offer very generous interest rates, but only at large risk.

Interest Rate Risk:

Debentures carry fixed returns. When interest rates in the debt market rise, 'debentures' lose their value, resulting in the market price of an existing debenture falling.

Inflation Risk:

Inflation slowly chips away at purchasing power. If inflation becomes persistent, an Rs 8,000 payment this year will buy less five years from now.

Kumar advises caution for conservative investors: "Risk-averse investors should avoid these debentures and should instead stick to FDs or gilt funds since debentures carry higher default risk and provide limited liquidity. So one should weigh it against the higher yields provided by debentures before allocating their money into it. However, a small allocation (under 5 per cent) in AAA-rated PSU may be considered for those seeking modest returns."