A debenture is a type of long-term debt instrument used by companies to raise funds from investors. It is essentially a bond that promises to pay back the principal amount with interest at a specified rate over a fixed period of time. Debentures may be secured (backed by collateral or specific assets of the company) or unsecured ( not backed by any collateral). In both instruments, Company’s creditworthiness, financial stability, and past performance remain important measures for investment into the NCDs.
Companies issue debentures as a way to raise capital for various purposes such as expanding their business, funding new projects, meeting working capital requirements, or refinancing existing debt. They are typically issued by larger, well-established companies with a strong credit rating, as investors generally prefer to invest in debt instruments issued by financially stable companies. Debentures can be traded in the secondary market, however, some debentures, typically issued by private companies are reserved for specific investors such as employees, directors, or promoters.
Basis redeemability and convertibility, debentures can be classified into various types:
Redemption: Redeemable debentures are those that have a fixed maturity date and are redeemed by the issuing company at the end of the tenure. Irredeemable debentures, also known as perpetual debentures, have no fixed maturity date and offer a fixed rate of interest. They may also be known as quasy equity.
Covertability: Debentures can also be classified based on convertibility, depending on whether the debentures can be converted into equity shares of the issuing company or not. The two types of debentures based on convertibility are:
Convertible Debentures
Convertible debentures are a type of bond that offers investors the option to convert their debentures into equity shares of the issuing company at a predetermined price or ratio. They are considered a hybrid security because they combine the features of both debt and equity. As a result, convertible debentures are a popular investment option for both individual and institutional investors.
Convertible debentures are an investment option that provides the potential for higher returns while also offering safety in the form of a fixed income instrument. They are an attractive investment option for retail investors looking for a balance between safety and the potential for capital appreciation. Convertible debentures can be fully or partially convertible:
Fully Convertible Debentures (FCDs)
Fully Convertible Debentures (FCDs) are debentures that can be fully converted into equity shares of the issuing company at a predetermined conversion price. The conversion price is usually set at a premium to the market price of the equity shares at the time of issuance. FCDs usually have a lower interest rate than NCDs because they offer the potential for capital appreciation through the conversion into equity shares.
Partially Convertible Debentures (PCDs)
Partially Convertible Debentures (PCDs) are debentures that are partially convertible into equity shares of the issuing company at a predetermined conversion price. The remaining portion of the debenture remains non-convertible and attracts a predetermined interest rate. PCDs offer investors a mix of fixed-income and equity participation.
Non-convertible Debentures (NCDs)
Non-Convertible Debentures (NCDs) are a type of debenture that cannot be converted into equity shares. They are usually issued for a fixed period of time, and the interest rate is predetermined. The interest on NCDs is generally higher than other fixed-income instruments like bank fixed deposits, and they offer investors a stable source of income.
NCDs are rated by credit rating agencies based on the issuer’s creditworthiness. Companies with a higher credit rating like AAA, AA are perceived as having a lower default risk, and their NCDs are consequently more in demand. NCDs can be issued in dematerialized form, which means that they are held electronically, and investors can trade them in the secondary markets.
Non-convertible debentures (NCDs) have some key features that differentiate them from convertible debentures. Here are some of the main differences:
Fixed Interest Rate
NCDs offer a fixed rate of interest, which is specified at the time of issuance. This provides a stable source of income to investors, as they know exactly how much they will earn from their investment, while convertible debentures may have a fixed or floating rate of interest.
Maturity
NCDs have a fixed maturity date, while convertible debentures may have a fixed or optional maturity date. This means that investors in NCDs can plan their investments more easily, while investors in convertible debentures have to consider the potential for conversion and the maturity date of the investment. For non-convertible debentures, the value at the maturity is the principal invested plus interest earned. For convertible debentures, it depends on whether the investor converts to equity shares or not, which can lead to higher returns but also more uncertainty. It highly depends on the company’s performance in stock market at that moment.
Low Risk
NCDs are generally less risky compared to convertible debentures. Since NCDs do not have any equity-linked risk, the principal amount invested and the interest earned are guaranteed by the issuing company. In contrast, convertible debentures come with the added risk of equity investment, as the conversion option depends on the performance of the issuing company
Higher Liquidity
NCDs are generally more liquid compared to convertible debentures, as they are listed on stock exchanges and can be easily traded. Convertible debentures, on the other hand, may not be as easily tradable, as the conversion option can add complexity and uncertainty to the investment.
When considering investing in non-convertible debentures (NCDs), here are some factors to keep in mind:
1. Credit rating of the issuing company: The credit rating of the issuing company reflects its financial stability and ability to pay back its debt obligations.
2. Interest rate offered: NCDs typically offer higher interest rates compared to other fixed-income investments like bank fixed deposits or government bonds. However, it’s important to compare the interest rates offered by different NCDs and choose the one that offers a competitive rate.
3. Tenure of the NCD: NCDs have a fixed tenure, and it’s important to choose a tenure that aligns with your investment goals and time horizon. If you need the funds in the near future, it’s best to choose a shorter tenure NCD.
4. Tradability: NCDs are more liquid than convertible bonds. The investors should look at the credit risk, remaining tenure, listing status, market conditions and interest rate environment to evaluate the tradeability
5. Issuing company’s track record: It’s important to check the track record of the issuing company, including its financial performance, debt repayment history, and industry trends.
Investing in NCDs can provide investors with a steady stream of fixed income over a specified period, typically with a higher interest rate than traditional fixed deposit schemes. With NCDs being less risky than equity investments, they can offer a good investment option for conservative investors seeking stable returns.
