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Understanding a Debenture

What is a debenture? What is “secured”? What is “non-convertible”? What factors should be considered while investing in a debenture? How does a debenture compare with company FD? What about debenture vs bank FD?

Let’s understand a debenture issue better.



What is a debenture?

A debenture is a debt instrument, just like a fixed deposit (FD), usually issued by a company. You invest a sum, and the company pays you a fixed rate of interest for the pre-defined period. After the period gets over, you get back your principal amount.

So, what is the difference between a debenture and a company fixed deposit (FD)? They are very similar – but the key difference is liquidity.

(Want to know more about bonds? Check out “What are bonds – Price, Coupon, Yield and more“)

Debentures can usually be traded in the market, meaning that you can exit your investment before the maturity date. Company FDs, in contrast, are quite illiquid.

Also, debentures are usually “secure”. (Read on for more on this)

Secure and Non-Secure

The debentures can be “secure” or “non-secure”.

“Secure” means that the amount the company accepts from you is tied to (or backed by) some assets of the company.

Thus, if the company fails and is wound up, you would be given a preference in repayment along with other secured creditors – the money raised from selling the assets of the company is first given to secured creditors before giving it to unsecured creditors and shareholders.

A “secure” debenture is a lot safer than a company FD, because a company FD is not secured against the assets of the company. If the company fails, secure debenture holders would be paid off before company FD holders.

Please note that even a bank fixed deposit (FD) is not a “secure” instrument.

“Non-secure” means that the amount the company accepts from you is not backed by the assets of the company. In this case, you would get a lower preference than secured creditors when a company is liquidated. However, you would get a higher preference than shareholders.


Convertibility

Debentures can be of three types:

  • Convertible
  • Non-Convertible
  • Partially Convertible

“Convertible” debentures

Here, you get an option to convert the debenture into shares of the company at a pre-decided date. The number of shares that you would get for each debenture (or the conversion price) is also pre-determined.

Thus, depending on the prevailing price of the company’s stock at the time of exercising this option, you can decide to convert your debenture into the company’s stock.

The benefit of “convertible” debentures is that you can benefit from the growth of the company – the conversion price (or the number of shares you would get per debenture) is pre determined based on the market price of the company’s shares at the time of the debenture issue.

If the company grows well, the share price can appreciate quite fast, and you can benefit tremendously as a holder of a convertible debenture.

“Non-Convertible” debentures (also known as NCD)

Here, the debentures are more like traditional fixed deposits. You can not convert them into shares – you get back the principal amount at the time of maturity.

“Partially Convertible” debentures

This is a combination or hybrid of convertible and non-convertible options. Here, a portion of the debenture is paid back to you, and a portion can be converted into equity shares of the company.


Credit Rating

Any debt issue usually obtains a credit rating from one of the credit rating agencies like CRISIL, ICRA or CARE.

Since the interest (and principal repayment) has to be paid from profits generated through the operations of the company, the riskiness of a debenture issue would depend on the issuing company. This is true even in case of secure debenture issues.

These credit rating agencies study the companies, and assign a credit rating to the debenture issue. The rating is expressed as a combination of alphabets, and is different for different rating agencies.

These credit rating companies publish the meaning of each rating, and you should study it before making the investment decision.

Put and Call Options

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 “call” option means that the company has an option to ask you to surrender the debenture, and pay back the principal to you.

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 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.

Listing on stock exchange

Debentures can be listed on a stock exchange, giving you an opportunity to sell them and exit earlier then the tenure of the debenture.

Rate of return

The interest rate offered (or the coupon rate) is usually in line with the prevailing market rates. Companies can offer a high rate of return to attract more investors.

Convertible debentures might offer slightly lower interest rate, as they already provide a lot of growth potential in the form of the facility to convert into shares of the company.

Tenure / Redemption

The tenor of the debentures can be quite varied, and depends on the company issuing it. However, a duration of 3 to 7 years is quite common.


Income Tax Treatment

For income tax purpose, the debentures are treated like debt instruments.

The interest earned would be treated as any other interest (say, from a bank FD). It would be a part of your “Income from other sources”, and would be taxable.

However, whether there would be TDS (Tax Deducted at Source) or not depends on many factors, and would vary from one debenture issue to another.

A debenture is a capital asset. 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.

(To know the currently applicable slabs, please read “Income Tax (IT) Slabs / Brackets and rates”)

If you sell it on an exchange after holding it for a year or more, the gain would be long term capital gain. This LTCG should be calculated without indexation, and would be taxed at 10% of the gain.

(To know more about classification and taxation of capital gains, please read “Long Term and Short Term Capital Gain – Income Tax Calculation”)

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