Debentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.
They are usually an unsecured form of borrowing from the public and have a lengthy tenure, usually exceeding ten years.
Table of contents
- Debentures are unsecured bonds or debt instruments released by a government authority or company to finance its long-term, capital-intensive projects.
- It is a form of loan that the investors extend to the issuer or borrower without asking for any collateral by relying upon the latter’s creditworthiness.
- Usually, the issuer pays a fixed interest at a coupon rate at regular intervals to compensate the investor. Also, the issuer can reimburse the borrowed amount in full on the maturity date or in fixed instalments payable at specific intervals.
A debenture is essentially a long-term loan that a corporate or government raises from the public for capital requirements. For example, a government raising funds to construct roads for the public. Debenture holders are the creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. of the issuing company, unlike a shareholderShareholderA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. who is the owner.
Just like bondholders, debenture holders also earn an interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. for investing in the debt instrument. The coupon ratesCoupon RatesCoupon Rate, also known as Coupon Payment, is the amount of interest that the bond issuers pay, based on the bond's face (or par) value & it is expressed as a percentage. You can calculate it by, Coupon Rate = (Total Annual Coupon Payment/Par Value of the Bond) *100 or interest rates are usually fixed unless when they are of the floating kind. A fixed rate of interest cushions against market fluctuations, making the investment less risky.
Debentures do not allow a claim over the issuer’s assets as they are largely unsecured debt instruments. The absence of collateral is offset by stable, low risk and better earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.. Also, a financially stable company with a reliable credit rating attracts investors as it reflects investment’s safety. Besides, with floating interest rates, earnings become better when rates improve.
Explanation of Debenture in Video
Features of Debentures
- Debentures are usually the unsecured form of bonds which are not backed by any asset or collateral. Instead, the investors consider the issuer’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan. as a primary parameter for the purchase. Also, being a long-term instrument, their tenure usually lasts for 10 years and above.
- They have a fixed coupon rate, at which the investors receive interest at specific intervals, i.e., monthly, quarterly, half-yearly or yearly. Some investors also get accumulated interest on redemption. Earnings change if the interest rates are floating. Market fluctuations and economic conditions affect interest rates.
- The issuing company pays off the interest as an expense before paying the dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.. The interest is thus tax-deductible, bringing down the taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation..
- Some companies issue debentures, which after a specified period, can be changed into equity stocks. This facilitates the investors to procure ownership in the organization and benefit from its earnings when its income is enhanced. In addition, the issuer enjoys low-cost borrowing since they offer a lower interest rate than non-covertibles.
- Repayments can be attained either in installments payable yearly or all at once. Thus, if the issuer pays off annual installments to the holders, it may do so by making a redemption reserve. Else, the issuer can repay the borrowed sum in a lump sum on the maturity date of the debt.
- They can be easily exchanged in the stock market, just like other securities. Thus, they are a flexible debt instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans..
- A real-world example is L&T Finance Ltd planning to issue secured, redeemable non-convertible debentures in 2012.
Types of Debentures
- Secured and non-secured: Apart from non-secured, companies also issue secured debentures in which investors hold a claim over the issuer’s assets.
- Convertible or Non-convertible: Convertible ones can be transformed into equity shares after a particular period. Conversely, the non-convertible type is a debt instrument that cannot be converted into equity shares.
- Perpetual: These bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. don’t have a maturity date, and the issuer need not redeem them. Instead, the issuer can opt to pay a regular interest for a lifelong period.
- Fixed Charge or Floating Charge: Under the fixed charge type, the unsecured bonds are locked at a predetermined or standard coupon rate throughout the holding period. Conversely, when the interest rates are floating, they vary with the changes in their benchmark rate.
The formula for computing total interest paid by the issuer is as follows –
Interest ExpenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense. = Interest Rate/ 100 * Debt Amount
ABC Ltd. issued $240000 debentures at 5% coupon rate. Determine the interest paid.
- Interest Expense = 5/100 * 240000
- Interest Expense = $12000
Whether the repayment methodology involves lump-sum or installment repayment, investors always try to find out the present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation. or the fair value of the investment. It helps in ascertaining its profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.. Therefore, let us calculate the debenture value when the repayment occurs in installments.
With each installment, the interest declines since the interests are calculated on an outstanding principal amount. When one deducts a repayment installment from the total debt, they are left with an outstanding principal amount. Therefore, we will need to calculate the present value of future interest payments and installments using a required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rate (yield to maturity)
Debenture value= (I1+P1)/(1+r)^1 +(I2+P2)/(1+r)^2+……….(I3+P3)/(1+r)^n
= ∑ t=1to n (It+Pt )/ (1+r)t
- It= Interest payment for a particular period
- Pt=Principal payment for the same period
- r = Yield to maturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond./ Required rate of return
An entity is issuing a debenture of 5 years, $1,000 to be remitted in equal installments at an 8% percent interest rate. The minimum required rate of return is 10%. Calculate the investment’s present value.
A table depicting the discounted cash flows in each period is shown below:
Debentures in Accounting
The issue can happen at par, discount and premium, and they all call for a distinct journal entry. So let us look at them.
Issued at Par
When the issue is at face value, it is said to be issued at par. Thus, for example, if a $150 debenture is issued and redeemed at par, the journal entries in accounting are as follows:
Issued at Premium
When the issue is at a price surpassing the investment’s face value, they are deemed to be issued at a premium. Thus, for example, if a $180 debenture is issued for $200 but redeemable at par, the journal entries in accountingJournal Entries In AccountingAccounting journal, often known as the book of original entry, is first used to record the company's accounting record whenever a financial transaction occurs. It's difficult to comprehend, yet it's crucial in business operations and accounting. are as follows:
Issued at Discount
When the issue is at a price lower than the investment’s face value, it is issued at a discount. For example, if an $800 debenture is issued and redeemable for $750, the following will be the journal entries:
Advantages and Disadvantages
Debentures are beneficial to the issuing company as they don’t risk the issuer’s assets. Also, the ownership is not diluted, unlike shares. Interest paid is also tax-deductible. As for the investors, these debt instruments contain low risk and have regular returns. Moreover, in situations like corporate dissolution, they are repaid before the common shareholders.
Investors may encounter various uncertainties like inflationary riskInflationary RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk. or earn lower than the prevailing market when the interest rate is fixed. Additionally, floating rates could fall heavily, bringing down the interest income. In case the issuer fails to repay, investors won’t recover their money.
Bonds vs Debentures
Bonds and debentures are both a means of raising capital from the public by the government or companies and are very similar in nature. Both can be repaid in one go or multiple installments and come with fixed or floating interest rates.
Whenever a bond is unsecured, it could be a debenture. Besides, they are issued occasionally. As opposed to that, there are many reliable age-old bonds in the market from the government, such as US Treasury Bonds.
A debenture is a form of unsecured debt instrument that a company or government issues at a particular coupon rate to acquire funds from the public, for example, an unsecured bond.
The significant difference between these two long-term debt instruments is that a bond provides a higher degree of security as many of them are backed with the physical assets of the issuer.
They are used as a source of leverage by the corporates and government organizations to fund expansion or new projects.
Yes, it is a kind of unsecured loan availed by the companies or government bodies by issuing debt instruments for a long tenure of ten years or more.
This has been a guide to what are Debentures and its meaning. Here we discuss the types of Debentures along with valuation examples, advantages, and disadvantages. You can learn more about financing from the following articles –