Types Of Debentures In Company Law

Debentures are a popular financial instrument used by companies to raise capital. They are essentially debt instruments that are not backed by collateral but by the general creditworthiness and reputation of the issuer. In the context of Indian finance, debentures are classified into several types based on various criteria such as security, tenure, convertibility, and redemption.

Types Of Debentures Based On Security

Classification Based on Security refers to the distinction between debentures that are either backed by specific assets (secured) or those that rely solely on the issuer's creditworthiness (unsecured).

1. Secured Debentures

Secured debentures are those that are backed by specific assets of the issuing company. In the event of default, debenture holders have a claim over the secured assets. These debentures offer a lower risk to investors as they are protected by the collateral provided by the company.

2. Unsecured Debentures

Unsecured debentures, also known as naked debentures, are not backed by any specific assets. Instead, they rely solely on the creditworthiness and reputation of the issuer. These debentures carry a higher risk compared to secured debentures, but they often offer higher interest rates to compensate for the increased risk.

Types Of Debentures Based On Tenure

Classification Based on Tenure refers to the categorization of debentures based on their maturity period, distinguishing between short-term, medium-term, and long-term debt instruments.

1. Redeemable Debentures

Redeemable debentures come with a specific maturity date on which the principal amount is repaid to the debenture holders. These debentures can be further categorized into:

• Fixed-term Debentures: These have a predetermined maturity date.
• Callable Debentures: The issuing company reserves the right to redeem these debentures before the maturity date at a predetermined call price.

2. Perpetual Debentures

Perpetual debentures, also known as irredeemable debentures, do not have a fixed maturity date. They are not meant to be repaid by the issuing company, and debenture holders receive interest indefinitely. These debentures are riskier as they do not offer a return of principal.

Types of Debentures Based On Convertibility

Classification based on convertibility refers to categorizing financial instruments or securities based on their ability to be converted into another form, such as shares or cash.

1. Convertible Debentures

Convertible debentures can be converted into equity shares of the issuing company after a specific period or on the occurrence of certain conditions. These can be further divided into:

• Fully Convertible Debentures (FCDs): These are converted entirely into equity shares.
• Partially Convertible Debentures (PCDs): A portion of these debentures is converted into equity shares, while the remainder continues to be in the form of debt.

2. Non-Convertible Debentures (NCDs)

Non-convertible debentures cannot be converted into equity shares and remain as debt throughout their tenure. These debentures typically offer higher interest rates compared to convertible debentures, as they do not provide any equity upside to the investors.

Classification Based On Redemption

1. Convertible Debentures

Convertible debentures allow investors the option to convert their debentures into shares of the issuing company after a specified period or upon reaching a predetermined condition. This type is attractive to investors who may prefer equity ownership in the future, particularly if they anticipate a rise in the company’s stock value.

• Partially Convertible Debentures (PCDs): A portion of the debenture amount is redeemed, and the rest is converted into equity shares.
• Fully Convertible Debentures (FCDs): Entire debenture amount is converted into equity shares of the issuing company.

2. Non-convertible Debentures (NCDs)

Non-convertible debentures are those which cannot be converted into equity shares. They remain purely as debt instruments and are redeemed on their maturity date. These debentures usually offer higher interest rates as compared to convertible debentures, compensating for the lack of conversion option.

Classification Based On Coupon Rate

1. Fixed Rate Debentures

Fixed rate debentures carry a fixed interest rate throughout their tenure. The interest payments are made periodically at the agreed-upon rate, providing predictability and stability in returns for investors.

2. Floating Rate Debentures

Floating rate debentures have interest rates that are not fixed but vary according to market conditions or a benchmark rate, such as the Mumbai Interbank Offered Rate (MIBOR). These debentures offer the potential for higher returns in a rising interest rate environment but can also result in lower returns if rates decline.

Classification Based On Registration

Classification based on registration separates debentures into registered ones, which are linked to specific holders, and bearer ones, which are transferable by delivery.

1. Registered Debentures

Registered debentures are issued in the name of a specific person whose name is recorded in the company’s register of debenture holders. These debentures can be transferred only through a regular instrument of transfer, ensuring a high level of security.

2. Bearer Debentures

Bearer debentures are not registered in the name of any individual holder. These are transferable by mere delivery and do not require any formal transfer instrument. The interest on bearer debentures is paid to the person who presents the coupon attached to the debenture.

Classification Based On Purpose

Classification based on purpose categorizes debentures based on their intended use or the security backing them, such as subordinated debentures and collateral debentures.

1. Subordinated Debentures

These are unsecured debentures that rank below other debts in terms of claims on the company’s assets. In case of liquidation, subordinated debenture holders are paid only after other debt obligations are satisfied.

2. Collateral Debentures

When a debenture is backed by specific assets as collateral, it is referred to as a collateral debenture. This added security reassures investors and can reduce the interest rate the company has to pay.

Advantages And Disadvantages Of Investing In Debentures

Investing in debentures offers both advantages, such as fixed returns and security, and disadvantages, including interest rate risk and lack of voting rights.

Advantages

• Fixed Returns: Debentures offer fixed and predictable returns, appealing to risk-averse investors.
• Higher Security: Certain types, like secured and first debentures, provide a degree of security by being backed by assets.
• Convertible Option: Convertible debentures offer a unique advantage by allowing debt to be converted into equity, potentially benefiting investors if the company performs well.

Disadvantages

• Interest Rate Risk: Floating-rate debentures are susceptible to fluctuations in market interest rates, which can reduce returns.
• Lack of Voting Rights: Unlike equity shareholders, debenture holders do not have voting rights in company decisions.
• Risk of Default: Unsecured debentures and second debentures carry a risk of default, particularly if the company faces financial challenges.

Conclusion

Debentures offer various options for investors, each with its unique features and risk profiles. Whether seeking steady income, long-term capital preservation, or convertible options, investors can find a debenture type that aligns with their financial goals. Understanding the different types of debentures is crucial for both issuers and investors to make informed decisions. Each type of debenture comes with its own set of characteristics, benefits, and risks, which must be carefully considered in the context of the overall financial strategy.