An Overview on Debt Instruments | Company

The below mentioned article provides an overview on debt instruments.

Debentures:

According to section 2(12) of the Companies Act, a “Debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not”. From this definition it is not very clear what is a debenture.

A debenture is a kind of document acknowledging the money borrowed containing the terms and conditions of the loan, payment of interest, redemption of the loan and the security offered (if any) by the company. Debentures are bonds issued by a company. Such bonds embody terms and conditions of loans, payment of interest, repayment of the loan etc.

Advantages and Drawbacks of Debentures:

Raising of finance through issue of debentures and bonds is one of the major sources of finance for a company and the important advantages and drawbacks are summarized as below:

Advantages:

The advantages of raising finance through issue of debentures are as follows:

(a) Trading on equity i.e., fixed cost capital help in increase in profits available for equity shareholders is one of the major objectives in raising finance by issue of debentures/bonds.

(b) The company approach funds for its projects without diluting control of its equity share­holders. The debenture-holders have no right to participate and vote in the shareholders meetings except in the case of class meetings.

(c) The company can adjust its gearing i.e., debt-equity ratio according to its financial plans just by redemption of debentures or raising of finance. This much ease is not available with the equity capital. The equity capital cannot ordinarily be redeemed or reduced in the ordinary course.

(d) The interest payable to the debenture-holders is a charge on profit and hence tax liability on the company’s profits is reduced, which result the debentures as a source of finance at cheaper cost as compared to the cost of equity capital and preference capital.

(e) At the time of winding up, the debenture-holders are placed before the share capital provides.

(f) Debentures are generally, secured on the assets of the company and, therefore, carry lesser risk and assured return on investment.

Drawbacks:

The following are the drawbacks in raising finance by issue of debentures:

(a) It is obligatory on the part of the company to pay interest at regular intervals and repayment of principal on scheduled dates. Any failure to meet these obligations may paralyze the company’s operations.

(b) The debenture trust deed will contain restrictive covenants which may not be favourable to the management control or equity shareholders.

(c) The financing through debentures is associated with financial risk of the firm. This will increase the cost of equity capital.

(d) Higher risks bring higher capitalization rates on equity earnings. Thus even though gearing is favourable and raises EPS, the higher capitalization rate attributable to gearing may drive down the market price of the ordinary shares.

(e) Debentures usually have a fixed maturity date. Because of this fixed maturity date, provision must be made for repayment of the cost.

(f) There is a limit to the extent to which funds can be raised through long-term debt.

(g) Since long-term debt is a commitment for a long period, it involves risk. During that time the debt may prove a burden, or it may prove to have been advantageous.

Debentures and Share Capital: Distinction:

Debentures do not form part of the capital of a company. Debenture-holders are the creditors of the company. Distinction between debentures and shares must be clearly understood.

(a) Debenture-holders are the creditors of the company while shareholders are the owners of the company.

(b) Interest on debentures must be paid irrespective of the fact whether the company has made any profit or not even if it has suffered a loss, while dividend (profit) can be paid to the shareholders only when the company has made any profit, otherwise not.

(c) Debentures are redeemable according to the terms of their issue while shares are never redeemable, except redeemable preference shares.

(d) Money received by the company by the issue of debentures is a loan, while money received by the issue of shares is the capital of the company.

(e) In the event of the company going into liquidation, debenture-holders have got a prior claim over the shareholders in regard to the return of the money, while the amount invested by the shareholders can be paid back to them only when all the liabilities are paid off and if there is any surplus.

(f) Holders of debentures issued after 1st April, 1956, have no voting right while a shareholder has a right of voting.

Convertible Debentures:

A company may also issue Convertible Debentures (CDs) in which case an option is given to the debenture-holders to convert them into equity or preference shares at stated rates of exchange, after a certain period. Such debentures once converted into shares cannot be reconverted into debentures. CDs may be fully or partly convertible.

In case of fully convertible debentures, the entire face value is converted into shares at the expiry of specified period(s). In case of partly convertible debentures only the convertible portion is converted into shares at the end of the specified period and non-convertible portion is redeemed at the end of certain specified period.

Non-convertible debentures do not confer any option on the holder to convert the debentures into shares and are redeemed at the expiry of specified period(s). CDs, whether fully or partly convertible, may be converted into shares at the end of specified period or periods in one or more stages. The company should get a credit rating of debentures done by credit rating agency. CDs are listed on stock exchanges.

Deep Discount Bond:

The IDBI for the first time issued Deep Discount Bond (DDB):

For a deep discount price of Rs. 2,700 an investor gets a bond with a face value of Rs. 1 lakh. The DDB appreciates to its face value over the maturity period of 25 years. The unique advantage of DDB is the elimination of investment risk. It allows an investor to lock-in the yield to maturity or keep on withdrawing from the scheme periodically after five years by returning the certificate.

The main advantage of DDB is that the difference between the sale price and original cost of acquisition will be treated as capital gain, if the investor sells the bonds on stock exchange. The DDB is safe, solid and liquid instrument. Investors can take advantage of these new instruments in balancing their mix of securities to minimize risks and maximize returns.

Zero Coupon Bonds:

Zero Interest Bonds (ZIBs) refer to those bonds which are sold at discount from their eventual maturity value and have zero interest rate. These certificates are sold to the investors for discount. The difference between the face value of the certificate and the acquisition cost is the gain to the investors. The investors are not entitled to any interest and are entitled to only repayment of principal sum on the maturity period.

The individual investors prefer ZIB because of lower investment cost and low rate of conversion to equity if ZIBs are fully or partly convertible bonds.

This is also a means of tax planning because the bonds do not carry any interest, which is otherwise taxable. Companies also find ZIB quite attractive because there is no immediate interest commitment. On maturity the bonds can be converted into equity shares or non-convertible debentures depending on the requirement of capital structure of a company.

Equity Warrants with NCDs:

Equity warrant is a piece of paper attached to a non-convertible debenture which gives the buyer or holder right to apply for and acquire an equity share at a future date.

The benefits for the corporate sector in case of equity warrants include the following:

(a) The equity warrant increases the marketability of debentures and reduces the need for the efforts of brokers/sub-brokers by way of private placement.

(b) The opportunity of receiving equity shares at a future date is a great attraction for investors, particularly in case of blue-chip companies.

(c) Lesser dependence on financial institutions and mutual funds for subscribing to the security.

(d) Wider dispersal of equity and lesser risk of takeover bids. The share can be bought by management through intermediaries.

(e) Provides an effective tool for long-term planning of capital structure to minimize cost of capital.

Benefits to Investors:

(i) Assured rate of interest over life on non-convertible debentures.

(ii) There is no extra cost of equity warrant but it has high price, depending on the financial performance of the company.

In conditions when the market is dampen in its response to the new issues, equity warrants can be added attraction for investors to apply for the issues, offering equity warrants with their securities.

Secured Premium Notes:

Secured Premium Note (SPN) is a tradable instrument with detachable warrant against which the holder gets equity share(s) after a fixed period of time. The SPN have feature of medium to long- term notes. With each SPN, a warrant may be attached to it, which will give the holder the right to apply for and get allotment of equity shares after certain period of time by which the SPN will be fully paid-up.

The investor can plan his tax affairs to minimize tax burden. It will be possible to spread interest income evenly over the life of the investment and that the premium as capital gains. For example, those who retire after fifth year of investment can opt for low premium to reduced tax liability.

Zero Coupon Convertible Note:

It is an instrument which can be converted into common stock of the issuer. If investors choose to convert they will be required to forego all accrued and unpaid interest. Zero coupon can generally be put to the issuer. This allows the issuer to obtain the advantages of convertible debt without too much dilution of common stock.

Like any zero coupon bond the issuer gets a tax deduction for imputed interest, even though no cash is paid until maturity. Investors are also benefited since they have the opportunity to participate in the underlying stock appreciation. If the appreciation does not materialize investors still have the regular scheme of interest income.

Debt for Equity Swap:

This instrument is an offer from an issuer of debt securities to its debt holders to exchange the debt for the issuer common or preferred stock. The issuer who wishes to offer debt for equity swaps does so with a view to increasing equity capital for the purposes of improving its debt-equity ratio and also enhance its debt raising capacity.

It also helps issuers to reduce their interest expenses and enables them to replace it with dividends on stock that are payable at their discretion. Investors get attracted because of the potential appreciation in the value of the stock.

Junk Bonds:

Junk bonds are corporate bonds with low ratings from a major credit rating agencies. High-rated bonds are called investment grade bonds, low rated bonds are called speculative-grade bonds or less formally called as ‘Junk bonds’. A bond may receive a low rating for a number of reasons. If the financial condition or business outlook of the company is poor, bonds are rated speculative- grade.

Bonds are also rated speculative-grade if the issuing company already has large amounts of debt outstanding. Some bonds are rated speculative-grade because they are subordinated to other debt i.e. their legal claim on the firm’s assets in the event of default stands behind the other claim, so called senior debt. Junk bonds are traded in a dealer market rather than being traded in stock exchanges. Institutional investors hold the largest share of junk bonds.

Development Financial Institutions:

With the increasing integration of Indian economy with the global economy, the financing requirements of corporate sector have undergone tremendous change, and accordingly, Develop­ment Financial Institutions in India have reoriented their policies and product range with much sharper customer focus to suit the varied needs of the corporate.

With a view to leverage new opportunities thrown open by the developments in the economy, the Development Financial Institutions have set up several subsidiaries/associate institutions offering a wide range of new products and services covering areas such as commercial banking, consumer finance, investor and custodial services, broking, venture capital financing, infrastructure financ­ing, registrar and transfer services, credit rating and E-commerce.

The All India Development Financial Institutions comprise six All India Development Banks (AIDBs), three Specialized Development Financial Institutions (SFIs) and three investment institutions.

At the State level, there are 18 State Financial Corporation’s (SFCs) and 28 State Industrial Development Corporations (SIDCs). Among the AIDBs, IDBI, IFCI, ICICI, IRBI and SCICI provide financial assistance to medium and large industries, whereas SIDBI caters to the needs of small and tiny industries.