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Wednesday, September 12, 2012

What are Debentures

Those of my investors who are close to the market may have recently heard of lot of noise around Non Convertible Debentures (NCDs) being issued by multiple corporates and open for general public. Before you invest, it is always advisable to get wise about Debentures in general, and Non Convertible Debentures (NCDs). So, i thought of writing this post on this important investment tool in your kitty. Here we go.

What are Debentures?
A debenture is a document that either creates a debt or acknowledges it, and it is a debt without collateral. (For understanding Collateral, refer to the earlier post Understanding Mortgage).
In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note, while in some other countries, bonds and debentures are separate instruments. (Refer to the section : "What is the difference between Bonds and Debentures" in the post below)
A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest.

What is the difference between Shares and Debentures?
Although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Debenture holders have no rights to vote in the company's general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the rights attached to the debentures. The interest paid to them is a charge against profit in the company's financial statements.

What are the different types of debentures?
Debentures are divided into different categories on the basis of: 
(1) Convertibility of the instrument 
(2) Security

Debentures can be classified on the basis of convertibility into:
• Non Convertible Debentures (NCD): These instruments retain the debt character and can not be converted in to equity shares
• Partly Convertible Debentures (PCD): A part of these instruments are converted into Equity shares in the future at notice of the issuer. The issuer decides the ratio for conversion. This is normally decided at the time of subscription.
• Fully convertible Debentures (FCD): These are fully convertible into Equity shares at the issuer's notice. The ratio of conversion is decided by the issuer. Upon conversion the investors enjoy the same status as ordinary shareholders of the company.
• Optionally Convertible Debentures (OCD): The investor has the option to either convert these debentures into shares at price decided by the issuer/agreed upon at the time of issue.

On the basis of Security, debentures are classified into:
• Secured Debentures: These instruments are secured by a charge on the fixed assets of the issuer company. So if the issuer fails on payment of either the principal or interest amount, his assets can be sold to repay the liability to the investors
• Unsecured Debentures: These instrument are unsecured in the sense that if the issuer defaults on payment of the interest or principal amount, the investor has to be along with other unsecured creditors of the company.

Why Convertible or Non Convertible Debentures?
"Convertibility" is a feature that corporations may add to the bonds they issue to make them more attractive to buyers. In other words, it is a special feature that a corporate bond may carry. As a result of the advantage a buyer gets from the ability to convert, convertible bonds or debentures typically have lower interest rates than non-convertible corporate bonds.
Non Convertible Debentures are debentures without the convertibility feature attached to them. As a result, they usually carry higher interest rates than their convertible counterparts.

Typical Features of Debentures
  • Debentures are listed on Stock Exchanges.
  • Issuance and Trading will be in De mat form only.
  • Interest will be paid through Direct Credit / ECS / RTGS / NEFT mode.
  • A good credit rating is required for the company to issue a Debenture.

Who Should Invest in Debentures?
  • Investors who expect a stable consistent return with least risk.
  • Investors who want to have consistent monthly returns. 
  • Fixed Deposit Investors can look at debentures to improvise their returns.
  • Investors looking at portfolio diversification with the Fixed Income security.
What is a difference between a bond and a debenture?
In many countries, Bonds and Debentures are separate instruments. Long‐term debt securities issued by the Government or any of the State Government’s or undertakings owned by them or by development financial institutions are called as Bonds
Instruments issued by other entities are called Debentures.

What is a Coupon rate?
The Coupon rate is simply the interest rate that every debenture/Bond carries on its face value and is fixed at the time of issuance.
For example, a 9% p.a coupon rate on a bond/debenture of  $ 100 implies that the investor will receive $ 9 p.a. as the interest. The coupon can be payable monthly, quarterly, half‐yearly, or annually or cumulative on redemption

What is Put and Call Options in Debentures?
Debentures can have put and / or call options.

• A “put” option means that you have an option to surrender the debenture if you want to, and get back your principal. A put option gives a lot of flexibility to you – if interest rates go up, and you can get better rates from the market, you can exercise the put option and get back your money. You can invest it elsewhere, and get better interest.

• A “call” option means that the company has an option to ask you to surrender the debenture, and pay back the principal to you. A call option gives flexibility to the company – if interest rates go down, and the company can get funds at lower rates from the market, it can exercise the call option and give your money back to you. It can then raise money from the market at lower rates.

Income Tax on Debentures / Bonds
For income tax purpose, the debentures are treated like debt instruments. Since debenture is a capital asset, no Income Tax is deductible at source.

If you sell the debenture on the stock exchange before holding it for a year, it would be a Short Term Capital Gain – it would be included in your income and would be tax as per prevailing IT slabs.
• If you sell it on an exchange after holding it for a year or more, the gain would be long term capital gain. This long term capital gain should be calculated without indexation, and would be taxed at 10% of the gain.

Benefits of investing in Debentures 
1) Better Returns: Debentures like NCD’s (Non Convertible Debentures) provide a higher rate of interest for their investors.
2) Good Liquidity: To sell NCDs, investor has two options.
    • Sell on the Stock Exchanges to anyone willing to buy
    • Exercise the Put /Call option and trade it back with the issuing corporate.

Related Links :
Understanding Mortgage

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