What are debentures? Meaning, types and features

When discussing investments, people often focus on stocks and mutual funds. However, India’s investment landscape offers a much wider range of opportunities. One such option is debentures. This article explores the meaning, features, benefits and drawbacks of debentures, and explains how they can help you balance your investment portfolio. 

Understanding debentures: Meaning and types 

The word ‘debenture’ is derived from the Latin word ‘debere’, which means ‘to owe’, and ‘debentur’, which means ‘are owing’. Debentures are essentially long-term debt instruments that companies issue to raise capital. Mostly unsecured, they are a type of loan that investors give to the issuing entity. In return, the issuer promises to pay back the principal amount on maturity along with periodic interest payments, also known as coupon payments. 

Features of debentures 

Here are five key features of debentures: 

1. Indenture/debenture agreement: Companies issue debentures through an indenture, a legal document that outlines the terms of the debenture. It typically includes details such as the debenture type, interest rate, maturity date and repayment terms. It also defines the rights and obligations of both parties. 
2. Interest rate/coupon rate: Debentures entitle investors to periodic interest payouts, which can be monthly, quarterly, half-yearly or yearly. The interest can be fixed or floating. While a fixed interest rate remains unchanged throughout the tenure, a floating interest rate varies based on market conditions. 
3. Credit rating: Debentures come with a credit rating to help investors assess the associated risk level. The rating usually ranges from AAA (highest safety) to D (default risk), as assigned by credit rating agencies. 
4. Rights: Although debenture holders become creditors of the issuing company, they do not receive any ownership or voting rights in the entity. However, secured debenture holders may get a claim on specific assets in case of default. 
5. Types: Debentures are classified into subtypes based on several factors such as security, convertibility and repayment terms. 

Types of debentures  

Here are some common types of debentures: 

1. Secured debentures: These debentures are backed by collateral, making them safer. In case of the issuer’s default, the repayments can be covered by the pledged asset. 
2. Unsecured debentures: These debentures have no collateral backing, making them riskier. However, they typically offer higher interest rates to compensate for the higher risk. 
3. Convertible debentures: These debentures can be converted into shares of the issuing company after a specific period, allowing investors to go from creditors to shareholders and benefit from potential stock price appreciation. 
4. Non-convertible debentures: These debentures can never be converted into shares and remain debt instruments until maturity. Hence, they often come with higher interest rates to compensate for the lack of conversion flexibility. 
5. Registered debentures: Registered debentures come with proper documentation. The issuer maintains a record of all debenture holders in a register. Such debentures can only be transferred through a formal transfer deed. 
6. Bearer debentures: These are unregistered debentures that can be transferred freely through physical delivery. Since there is no record of ownership, the holder of the debenture certificate becomes the legal owner. 
7. Redeemable debentures: These debentures mature after a fixed period, making it obligatory for the issuer to repurchase them from investors at face value on the due date. 
8. Irredeemable debentures: Also known as perpetual debentures, these do not have a fixed maturity date. The issuing company is not under any obligation to repay the principal unless it dissolves or chooses to repurchase the debenture. However, it must continue making interest payments indefinitely. 

Now that you understand debentures’ meaning and types, let’s move on to their advantages and disadvantages. 

Advantages of investing in debentures 

Here are some advantages of buying debentures: 

1. Steady income: Debentures offer regular interest payments, providing a predictable source of income. 
2. Liquidity: Most debentures are freely tradable in secondary markets. This offers liquidity and enhances financial flexibility. 
3. Diversification: As fixed-income instruments, debentures help balance portfolio risks and reduce dependence on highly volatile equities. 
4. Safety: Secured debentures are issued against collateral, ensuring protection for principal and interest payments. Furthermore, in the event of bankruptcy or liquidation, debenture holders are paid before shareholders. 

Risks associated with debentures 

Debentures come with certain risks, including: 

1. Interest rate risk: If the market interest rates rise, fixed-rate debentures may become less attractive as newer debentures may offer better rates.  
2. Credit risk: This risk refers to the probability of the issuer defaulting on principal or interest payments. The risk increases further for unsecured debentures. 
3. Liquidity risk: While most debentures are tradable in the secondary market, some may offer limited liquidity, making it difficult to sell at a favourable price. 
4. Taxation impact: Interest on debentures is taxable as ‘Income from Other Sources’ as per the applicable tax slab. Tax Deducted at Source (TDS) may also apply in certain cases. Moreover, gains from the sale of debentures are subject to capital gains tax, with rates depending on the holding period. 

Shares vs debentures: Key differences 

How to invest in debentures? 

You can invest in debentures through the primary market or the secondary market. 

• Primary market 

When a company issues debentures for the first time, you can subscribe to them through an Initial Public Offering (IPO). This can be done either offline or online via any of the following: 

1. Self-certified Syndicate Banks (SCBs)
2. Authorised intermediaries such as brokers and investment advisors 
3. Stock exchanges through a registered trading account 
4. Online bond platforms like GoldenPi, registered under the Securities and Exchange Board of India (SEBI)

• Secondary market

You can also own debentures after the IPO period by purchasing them on stock exchanges. You can log into your demat and trading account and place a buy order. After the trade is executed, the debentures will be credited to your demat account within T+2 days (Trade date + 2 working days).

Conclusion

Debentures are debt securities that you can add to your portfolio alongside equity to minimise risk and maintain stability.