Debenture holders are the people who own the debt of a company. Debenture holders are usually institutions like banks, pension funds, and insurance companies. Debentures are often secured by collateral such as land or shares in the company. The interest rates for debentures can be fixed or variable. Let us understand it in details.
What is a Debenture?
A debenture is a debt instrument that relies on the issuers’ creditworthiness. It is a type of bond with no collateral backing. They are usually held for a term of more than ten years. Governments and corporations both issue debentures frequently to raise funds or capital. Debentures have longer repayment dates and lower interest rates than other debt instruments, hence always a choice by the companies.
Like most bonds, debentures are mentioned in an indenture, a legal contract between bondholders and bond issuers. This contract holds all the details like maturity date, method of interest calculation, and when to make the coupon payments.
Coupon payments are periodic interest payments against the debenture. The coupon payments for these debt instruments are made on a fixed date. A company ideally releases these payments before paying the dividend to its shareholders.
Who are Debenture Holders?
A Debenture Holder is the creditor of the company, also known as the lender of the company. They issue this debt instrument and get a fixed rate of interest in return. Debentures are considered secured because they are often issued against the assets of the company; hence the debenture holders are secured creditors.
Debenture holders are often confused as the co-owner of the company since they are the credit providers, but it is not true. Shareholders are the joint owners of the company or organization because they subscribe to the shares, which is a part of share capital. On the other hand, Debenture holders provide credit to the company, which is a part of the loan. Hence, they are only the creditors of the company.
Debenture Holder, being the secured creditor, receives an assured interest, irrespective of profit or loss incurred by the organization. If need be, he will be paid from the company’s capital too. Convertible Debentures can be converted into shares anytime the holder wants. On the contrary, shares can never be turned into debentures, and shareholders will receive dividends only if the company is in profit. Hence a debenture holder is always paid-off before shareholders in case the company goes bankrupt or winds up.
Debenture Holders do not have any part in the company’s decision-making unless it affects the interest-bearing capacity of the company. They stay unaltered by the management and regulatory decisions of the company; on the other hand, shareholders control the company affairs and are invited to the annual meeting as well.
Risk of Being a Debenture Holder
While Debenture holders may have a secured agreement, be the first ones to be paid, and receive steady coupon payments, there is a certain risk involved in holding this debt instrument.
1. Inflationary Risk
Inflation is an economy-based price increase, in other terms, when the cost of living in the country goes up. The risk of debts interest rate not coping with the inflation rate is called inflationary risk. Debenture Holders may be on the losing end with this risk involved because the real value of the investment will be reduced due to unanticipated inflation, eventually undermining the asset performance.
For instance, if the coupon payment rate is 2% and the inflation rate is 4%, the holder may incur a net loss.
2. Default Risk
Debentures carry the risk of credibility. It is only as secure as the financial strength of the issuer. The financial stability of the company is affected by macroeconomic and internal factors. If the company is undergoing financial trouble, the investors are at risk because the company may default on the debenture. However, the Debenture holder will be paid before the shareholders in case of bankruptcy.
3. Interest Rate Risk
Debentures hold interest rate risk. Interest rate risk is when the rate of interest on investments is on the rise while you have a fixed rate of interest on your bond, leading to the decline in the value of your investment in the long term. This risk can be minimized if the investors hedge the fixed investments with interest rate derivatives like swaps and options. The duration of the bond often measures this risk since long-term bonds are more price sensitive.
What do Debenture Holders receive as the ROI?
It is stated that the debenture holders receive steady payments at a fixed rate and time, which is called the coupon payment. Other than this, what is the return on investment for a Debenture Holder?
Kinds of Debentures
There are two kinds of debentures, convertible and non-convertible.
Convertible Debentures are convertible bonds, which mean they can be converted into equity shares of the company after a certain period of time. Convertibility of bonds into shares is an attractive feature to get more investors. These debentures carry a lower interest rate but allow the holder to convert them into shares and become the co-owner of the company from just a creditor. It gives them the freedom to enjoy share profits and coupon payments if they believe the company’s stock prices will rise.
Non Convertible Debentures, on the other hand, are like any regular debentures that cannot be converted into the equity shares of the liable company. They usually have a higher interest rate attached to them as a reward for non-convertibility.
Key Differences between Debenture Holders and Share Holders
Debenture holders and Shareholders are two sides of the same coin, the coin being the company. Why do I say this? It’s because a company has two ways to raise funds, either by floating shares or by issuing debentures. While the end goal is the same, they have fundamental key differences.
|Debenture Holders||Share Holders|
|Debenture Holders are the lenders of the company, also known as creditors.||Share Holders are the co-owners of the company.|
|They are oblivious to the decision making process.||They are actively involved in the decision making process.|
|They receive steady interest payments, even though the company is making profits or not.||They receive dividends when the company makes a profit and chooses to pay a dividend.|
|They are paid first in case of bankruptcy since a collateral is attached to the bond.||A company usually defaults on paying the shareholders, in case of bankruptcy.|
Here is everything you need to know about debentures, debenture holders, their characteristics and how they are different from shareholders. Being a debenture holder highly depends on your lending and risk enduring capacity. Check the difference between ordinary shares and preference shares.