Capital Markets [Part-2]
Debt Capital and Debt Instruments
Debentures or bonds are debt instruments which pay interest over their life time and are used by companies to raise medium or long term debt capital. If an investor prefers fixed income, he / she may invest in these instruments which may give him / her higher rate of interest than bank fixed deposit.
- In the Indian securities markets, the term ‘bond’ is used for debt instruments issued by the Central and State governments and public sector organizations and the term ‘debenture’ is used for instruments issued by private corporate sector.
The Debt Instruments may be Corporate Debt or Government Debt. Corporate debt instruments are generally called Debentures while Government debt instruments are generally called Bonds, but Bonds can be issued by companies and local governance bodies too.
A debenture is one of the capital market instruments which is used to raise medium or long term funds from public. A debenture is essentially a debt instrument that acknowledges a loan to the company and is executed under the common seal of the company. The debenture document, called Debenture deed contains provisions as to payment, of interest and the repayment of principal amount and giving a charge on the assets of a such a company, which may give security for the payment over the some or all the assets of the company. Issue of Debentures is one of the most common methods of raising the funds available to the company. It is an important source of finance.
Salient Features of Debentures
The most salient features of Debentures are as follows:
- A debenture acknowledges a debt
- It is in the form of certificate issued under the seal of the company (called Debenture Deed). It usually shows the amount & date of repayment of the loan.
- It has a rate of interest & date of interest payment.
- Debentures can be secured against the assets of the company or may be unsecured.
- Debentures are generally freely transferable by the debenture holder. 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.
Types of Debentures
The debentures can be divided into various types on the basis of security, performance, priority, convertibility and Records as shown in the below graphics:
What are naked debentures and secured debentures?
- Naked Debentures: These Debentures are not secured against any assets of the Company. In case of winding of the company, debentures holders holding unsecured debentures treated as unsecured creditors.
- Secured Debentures: These Debentures are secured by a charge on the assets of the company. These debentures are secured either on particular assets called fixed charge or on the general assets of the company called floating charge. The debentures holder has a right to recover outstanding loan & interest out of such charge assets. These debentures are issued by the company under an agreement which is called “Mortgage Deed”. Such mortgage is registered with Register of Companies.
What are Redeemable and Irredeemable debentures?
- Redeemable Debentures: The debentures are redeemed by repayment of the amount of debentures after a specified date, as per terms & conditions issued.
- Irredeemable Debentures: In this case the issuing company does not fix any date by which debentures should be redeemed & the debentures holder cannot demand repayment of the sum of debenture from the company so long as it is going concern.
What are first debentures and second debentures ?
- First debentures: This type of debentures are repaid before the repayment of other debentures.
- Second debentures: These debentures are paid after payment of first debentures.
What are convertible debentures and non-convertible Debentures?
- Convertible debentures: Holders of such debentures are given option to convert the debentures fully or partly into equity shares or preference shares or new debentures after a specified time.
- Nonconvertible debentures: The holders of this type of debentures do not have any right to convert them into equity shares etc.
What are bearer debentures and registered debentures?
- Bearer debentures: Just like bearer cheques these debentures can be transferred freely. Payment of interest is made on productions of coupons attached with debentures.
- Registered debentures: These are transferred only by transfer deed. The complete particulars in regard to such debentures are entered into register & the interest is paid only to those whose name appears in the register.
What are at par, at premium and at discount issue of Debentures?
Debentures can, be issued in three ways.
- At par:Debenture is said to have been issued at par when the amount collected for it is equal to the nominal value of debentures. e.g. the issue of debentures of Rs. 100/- for Rs. 100/-
- At Discount:Debenture is said to have been issued at discount when the amount collected is less than the nominal value, for e.g., issue of debentures of Rs. 100/- for Rs. 95/-. The difference of Rs. 5/- is the discount and is called discount on issue of Debentures. This discount on issue of debentures is a capital loss.
- At Premium:When the price charged is more than its nominal value, a debentures is said to be issued at a premium. e.g., issue of debentures of Rs. 100 each for Rs. 120, the excess amount over the nominal value i.e., Rs. 20 is the premium on issue of debentures. Premium received on issue of debentures is a capital gain. Please note that this Premium on issue of debentures cannot be utilised for distribution of dividend. Premium on debentures is shown under the head Reserves & Surplus on the liability side of the Balance Sheet.
What is Issue of Debentures for Cash?
Debentures may be issued for cash at a par, at a discount or at a premium. When amount is payable in instalments entries will be similar to the issue of shares. Any premium or discount on issue of debentures is usually adjusted at the time of making allotment. Premium payable on redemption of debentures is also adjusted at the time of issue of debentures.
What is Issue of debentures for non-cash consideration?
Debentures may be issued for consideration other than cash such as acquisition of business, or assets. It should be noted that ouch debentures may be issue at par or at a premium or at a discount.
What is Issue of debentures as a collateral security?
Debentures can be issued as collateral security against a loan or overdraft from bank or other financial institution. Collateral Security means an additional or parallel security.
What is Redemption of Debentures?
Debentures may be redeemed (repaid) a) at a par b) at a premium or c) at a discount.
- Redeemable at par:When debentures are to be redeemed at their face value they are said to be redeemable at par.
- Redeemable at a premium:When debentures are to be redeemed at an amount higher than their face value they said to be redeemable at a premium. Premium payable on redemption of debentures is a capital loss for the company. Such premium even though payable on redemption must be provided as a liability at a time of issue of debentures.
- Redeemable at a discount:When debentures are to be redeemed at an amount lower than their face value, they are said to be redeemable at a discount such discount is a capital profit for the company.
How debentures are different from bonds?
Bonds and Debentures, both are similar and holders of both of them are creditors to the company. Both bonds and debentures can be secured or unsecured. Generally, the bonds issued by the companies are secured by their assets. But there are unsecured bonds as well. The bonds issued by municipalities or government companies etc. are normally not secured by any assets.
Both bonds and debentures get priority over shares when company is liquidated. However, if the bonds are secured, they get priority over unsecured debentures.
What is Convertibility in Debentures?
Convertibility in debentures denotes conversion of a debenture to equity shares. On this basis they are of four types as follows:
- 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.
- Non Convertible Debentures (NCD):Non-convertible debentures , which are simply regular debentures, cannot be converted into equity shares of the liable company. They are debentures without the convertibility feature attached to them. As a result, they usually carry higher interest rates than their convertible counterparts. Thus, these instruments retain the debt character and can not be converted in to equity shares
The key difference between a share and a debenture is that while share represents part of ownership of a company, debenture acknowledges loan or debt to the company.
|Share capital is an ownership capital.||Debentures capital is credit to the company.|
|A shareholder is the owner of the company.||A debenture holder is the creditor of the company|
|Share capital is not returnable in the life time of the company. However, the redeemable preference shares are refunded during the life-time of the company.||Debenture capital returnable during the lifetime of the company. The exception is the irredeemable debentures which are not redeemable during the life-time of the company.|
|Equity Shareholders enjoy the voting rights.||Debentures holders do not have the voting rights.|
|Dividend is payable on shares & it is an appropriation of profits||Interest on debentures is payable at a fixed rate on specified date irrespective of profits of the company.|
|Dividend depends on the profit of the company||Interest is paid on debentures & it is a charge on the revenue of the company.|
|Shares are unsecured.||Debentures are generally secured.|
|In the event of winding up of the company shareholders are the last person in re-fund of their capital.||Debenture holder being the creditors are paid prior to the shareholders. If secured they have priority even over the unsecured creditors.|
Government securities (G-Secs) are instruments issued by Government of India to raise money. G Secs pays interest at fixed rate on specific dates on half-yearly basis. It is available in wide range of maturity, from short dated (one year) to long dated (up to thirty years). Since it is sovereign borrowing, it is free from risk of default (credit risk). The investors can subscribe to these bonds through RBI or buy it in stock exchange.
The Hybrid Instruments are a combination of ownership and loan instruments. Examples are Preference Shares, Cumulative Preference Shares and Cumulative Convertible Preference Shares. Preference shares are also known as Preferred Stock. The Preference share entitle the investors to receive dividend at a fixed rate. This is the major difference between the equity share holder and preference share holder that the later gets dividend at a fixzed rate. This dividend had to be paid to the investor before dividend can be paid to equity shareholders. In the event of liquidation of the company, the claim to the company’s surplus will be higher pf the holders of Prefernce shares than that of the equity holders, but however, below the claims of the company’s creditors, bondholders / debenture holders. This means that if a company is liquidated, the payment will be done in the following order:
Creditor’s →Debenture / Bond Holders →Preference share holder’s → Equity Share Holders