A debenture represents the smallest unit of public lending to a company. Like shares, they are represented in the form of a certificate. The common face value for a debenture in India is Rs.100, and they are always issued at par. Unlike an ordinary shareholder, a debenture holder assumes very little risk on his investment. Unlike the uncertain stream o dividends, which a shareholder receives, a debenture holder receives a fixed stream of interest. Payment of such interest is a legal obligation on the part of the company. Further, in general, a debenture is required to be secured against the assets of the company. Thus, a debenture is also a form of a secured loan. Secured debenture implies that should a company default in its obligations towards debenture holders in the repayment of their interest and principal, in law, the charged assets can be sold off for meeting such obligations. Thus, debenture holders are investors who assume relatively little risk on their investment and accordingly the returns they can expect to earn are lower than that of ordinary shareholders. Debenture holders, since they are lenders of capital and not owners, do not have voting rights, except under exceptional circumstances. Unlike dividend, interest on debentures is deductible form the corporate profits. This means that interest payments are made from the pretax operating profits of a company.
KINDS OF DEBENTURES IN THE CORPORATE SECTOR
Debentures are essentially of three kinds, fully convertible(FCD), partly convertible (PCD) and non-convertible (NCD).
- Fully Convertible debentures (FCD) :- A fully convertible debenture is a debenture which, at a specified time after the issue, is fully converted to equity at the option of the holder.
- Partly Convertible Debenture (PCD) :- As the name suggests, a partly convertible debenture is a debenture only a part of which is convertible into an ordinary share. For example, a debenture priced at Rs.100 may have two components, namely, (A) – a convertible component (B) - a non-convertible component priced at Rs.30 and Rs.70 respectively. Here only component (A) priced at Rs.30 is convertible into an ordinary share, while the non-convertible component (B) priced at Rs.70 is allowed to remain intact.
- Non-convertible Debentures (NCDs) : – These debentures cannot be converted into ordinary shares. Frequently, these debentures may redeemable with a small premium (usually 5% of the principal). They may also be irredeemable or perpetual. In India, the interest rate on non-convertible debentures paid by the companies is usually 2 to 2.5% higher than that for convertible debentures.
Under the SEBI guidelines, conversion must take place at or after 18 months at the option of the debenture holder. The guidelines also require that all debentures with conversion or maturity over 18 months be credit rated and that the premium amount at the time of conversion, the period of conversion, the redemption amount, period of maturity and yield on redemption be indicated in the prospectus.
Ordinarily, a convertible debenture is converted into the shares of the company issuing the debenture. However, in principle, there is no reason why the debentures of a company cannot be converted into the shares of another company. In many countries, such a practice does exist. Such innovations are bound to enter our own market before long.
A bond is more or less the same as a debenture. In India, the terms bonds and debentures are mostly used interchangeable. There is virtually no distinction between the two, and the difference if any is subtle enough to be disregarded for all practical purposes. Some, however, regard a bond as an American term for a debenture. Others prefer to reserve the term ‘bonds’ for public debt securities belonging to the government and public sector undertakings.
ZERO COUPON or A DEEP DISCOUNT BOND :
A zero coupon bond or a deep discount bond is a loan instrument slightly different from an ordinary debenture. Unlike an ordinary debenture, which is usually offered at its face value (say Rs.100) and earns a stream of interest till redemption (say 15% per annum) and is redeemed with or without premium, five-year zero coupon bond may be offered at a discount (say at Rs.50), and fetches no periodic interest and is redeemed at the face value (say Rs.100). a little computation revels that the yield to maturity or YTM of such a zero coupon bond when subscribed to at Rs.50 is about 15%, which is similar to that of an ordinary debenture subscribed to at face value, which is redeemed without premium. It is simply; that instead of receiving the interest periodically, the bondholder receives the principal as well as compounded interest together at the time of maturity of the bond. In other words, the interest is automatically reinvested at 15% per annum till maturity.
The implication of such an instrument in India may be of significance to the investors in the high-tax brackets, depending upon whether or not they can treat the implicit interest accrued at the time of redemption as capital gains. Since the interest on the bond is received only at the time of redemption, if it is allowed to be accounted for as premium at redemption attracting capital gains tax rather than income tax, the bond may have a special attraction (since the capital gains tax rate is in general lower than the income tax rate). In the developed countries, however, investors must pay income tax on the implicit coupon interest every year, even though they do not actually receive the interest.