All that there is to know about Debentures
Published by Sharekhan Education | May 30, 2021
All that there is to know about Debentures
Companies use debentures as an investment vehicle to raise capital in the form of long-term debt. They issue debentures as either secured (backed by collateral support) or unsecured (not backed by collateral support). Most of the companies listed on stock exchanges usually issue unsecured debentures backed by the creditworthiness of the issuer.
Similar to bonds, the debentures may pay a coupon payment (interest) and can have a maturity date (the date on which principal on the debentures become due). Companies, governments, and SPVs issue debentures, and regulatory bodies such as RBI, SEBI, and regulators under the Companies Act oversee their regulation.
There are commonly three kinds of debentures, such as:x
1. Fully Convertible Debentures
2. Partly Convertible Debentures
3. Optionally Convertible Debentures
Let’s first understand what convertible debentures are. Convertible Debentures are debt instruments that can be converted into equity shares of the company at a future date. This is a type of hybrid investment vehicle that has features of both debt and equity. It pays interest like any other debt instrument until the conversion date and at a pre-defined time after which the debt gets converted into equity shares.
Now let’s understand the types of convertible debentures.
Fully Convertible Debentures: These debentures exhibit all the characteristics of convertible debentures, and the issuer converts the entire value of the debentures into equity shares.
Partly Convertible Debentures: These debentures have all the characteristics of convertible debentures. However, the issuer converts only a portion of the debentures into equity shares. The non-convertible portion remains as debentures, earns interest, and the issuer repays it upon redemption (at the maturity date).
Some of the basic characteristics of debentures generally include:
- The date on which or before which conversion is to be made,
- The ratio of conversion (i.e. number of shares that will be issued against each debenture),
- The price at which shares will be issued to debenture holders on conversion, usually, it is at a discount to the market price, and
- The proportion of the debenture that will be converted into equity shares (in case of partially convertible debentures)
Advantage of the convertible debentures to issuer:
Convertible debentures have a lower interest payment than a regular debt instrument because the yield to debenture holder is not just from interest payment but also from the possible capital appreciation, once the debentures are converted to equity shares. Also, the issuer does not have to repay the debt as the shares are issued in lieu of the repayment.
The advantage to the debenture holders:
They get the benefit of both debt and equity, as they earn interest in the initial phase and then benefit from a possible capital appreciation on the conversion of debentures to shares.
The disadvantage to debenture holders:
Debentures are exposed to the risk of inflation if the interest does not keep up with inflation. And the share price does not appreciate or rather depreciate after conversion into equity shares.
The disadvantage to existing shareholders of the issuing company:
The disadvantage of the convertible debentures is usually to the existing shareholders of the company as the conversion leads to dilution of stake and leads to possible lower earnings per share (net profit divided by the number of issued shares).
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