Debentures, Kinds of Debentures

Debentures are a debt instrument used by companies and government to issue the loan. The loan is issued to corporates based on their reputation at a fixed rate of interest. Debentures are also known as a bond which serves as an IOU between issuers and purchaser. Companies use debentures when they need to borrow the money at a fixed rate of interest for its expansion.

A Debenture is the acknowledgment of the debt the organization has taken from the public at large. They are very crucial for raising long-term debt capital. A company can raise funds through the issue of debentures, which has a fixed rate of interest on it. The debenture issued by a company is an acknowledgment that the company has borrowed an amount of money from the public, which it promises to repay at a future date. Debenture holders are, therefore, creditors of the company.

Advantages of Debentures

• Investors who want fixed income at lesser risk prefer them.
• As a debenture does not carry voting rights, financing through them does not dilute control of equity shareholders on management.
• Financing through them is less costly as compared to the cost of preference or equity capital as the interest payment on debentures is tax deductible.
• The company does not involve its profits in a debenture.
• The issue of debentures is appropriate in the situation when the sales and earnings are relatively stable.

Disadvantages of Debentures

• Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces.
• With redeemable debenture, the company has to make provisions for repayment on the specified date, even during periods of financial strain on the company.
• Debenture put a permanent burden on the earnings of a company. Therefore, there is a greater risk when the earnings of the company fluctuate.

Types

• Registered Debentures:

These are debentures which are payable to the registered holders i.e., persons whose names appear in the Register of Debenture holders. Such debentures are transferable in the same way as shares.

• Bearer Debentures:

Bearer debentures are similar to share warrants in that they too are negotiable instruments, transferable by delivery. The interest on bearer debentures is paid by means of attached coupons. On maturity, the principal sum is paid to the bearers.

• Redeemable Debentures:

These debentures are issued for a specified period of time. On the expiry of that specified time the company has the right to pay back the debenture holders and have its properties released from the mortgage or charge. Generally, debentures are redeemable.

• Perpetual or Irredeemable Debentures:

A debenture which contains no clause as to payment or which contains a clause that it shall not be paid back is called a ‘perpetual debenture’ or ‘irredeemable debenture’. These debentures are redeemable only on the happening of a contingency or on the expiration of a period, however long. It follows that debentures can be made perpetual, i.e., the loan is repayable only on winding up or after a long period of time.

• Secured Debentures:

When any particular or specified property of the company is offered as security to the debenture-holders and when the company can deal with it only subject to the prior right of the deben­ture-holders, fixed charge is said to have been created.

On the other hand, when the debenture-holders have a charge on the undertaking of the company i.e., on the whole of the property of the company, both present and future, and when it can deal with the property in the ordinary course of business until the charge crystallizes i.e., when the company goes into liquidation or when a receiver is appointed, the charge is said to be a floating charge.

When the floating charge crystallizes, the debenture-holders have a right to be paid out of the sale proceeds of the assets subject to the right of the preferential creditor but prior to making any payment to unsecured creditors.

• Naked Debentures:

Normally debentures are secured by a mortgage or a charge on the company’s assets. However, debentures may be issued without any charge on the assets of the company. Such debenture is called ‘naked debenture’ or ‘unsecured debenture’. They are mere acknowledgment of a debt due from the company, creating no rights beyond those of unsecured creditors.

• Debentures Issued as Collateral Security for a Loan:

The term collateral security or secondary security means, a security which can be realized by the party holding it in the event of the loan being not paid at the proper time or according to the agreement of the parties. At times, the lenders of money are given debentures as a collateral security for loan. The nominal value of such debentures is always more than the loan. In case the loan is repaid, the debentures issued as collateral security are automatically redeemed.

On the Basis of Terms and Conditions

As Regards Security:

• Naked, unsecured or simple debentures are issued with merely a promise of payment, without any security by way of charge on the assets of the company for the payment of interest or capital;
• Secured or mortgage debentures are those debentures which are issued with a charge on the undertaking and assets of the company as security. The charge may be fixed, i.e., on a particular asset, or it may be floating, when it does not fasten on any asset until it crystallises.

As Regards Registration or Records:

• Registered debentures are payable to a holder whose name, address and particulars of the holdings are entered in the register of debenture-holders maintained by the company. They can be transferred by a regular transfer deed and the transfer must be registered with the company;
• Bearer debentures are payable to the bearer and are transferable by mere delivery. They are negotiable instruments, and the company keeps no records in respect of them. Interest coupons are attached to them and interest is paid to a person who produces the coupons.

As Regards Repayment or Redemption:

• Redeemable debentures are those the repayment of the principal by the company on which is to be made on a specified date, or by instalments either at company’s option or at fixed intervals as long as the company is a going concern;
• Irredeemable debentures or perpetual debentures are those in respect of which no time is fixed in which the company is bound to pay, although it may pay back at any time it chooses. The debenture-holders cannot demand payment as long as the conn any is a going concern and does not make default in payment of interest. But all debentures, whether redeemable or irredeemable, become payable on the company going into liquidation.

As Regards Status:

• Equitable debentures are those which are secured by deposit of little deeds of the property with a memorandum in writing creating a charge;
• Legal debentures are those in which the legal ownership of the property of the company is transferred by a deed to the debenture-holders as security for the loans.

As Regards Rank or Priority:

• Preferred or First debentures are those which are, in the event of winding up of the company, paid first.
• Ordinary or Second debentures are paid after the preferred, or first debentures have been redeemed.

As to Conversion:

• Convertible debentures are those in which an option is given to the debenture-holders to exchange their debentures for shares in the company under certain conditions and limitations imposed regarding the period during which the option may be exercised;
• Non-convertible debentures cannot be exchanged for shares, and the debenture-holder cannot change his status to a shareholder.