Different Types of Debentures in India
Debentures are fixed income instruments that represent loans given by debenture buyers (investors) to debenture issuers (borrowers).
Debentures and bonds are two types of fixed income instruments. While they refer to completely different types of instruments in the US and UK context, the line between bonds and debentures is quite blurred in India.
The differences between debentures and bonds are discussed in detail here : Bonds vs Debentures in India
What are debentures and who issues them?
Debentures are financial instruments issued by companies to finance their projects and operations. Debentures are purchased by retail investors, other companies and even foreign entities like pension funds and hedge funds to generate returns on their investment.
But the world of debentures is vast because of the sheer types of debentures that exist in India. Let’s take a look at some of the most important types of debentures in India.
Types of debentures
Debentures can be classified based on several factors. Here are the most important ones:
- Record keeping
- Coupon payment
- Principal protection (MLDs)
- Convertibility to stock
Types of debentures based on issuer
While debentures can be issued by any corporation, we can classify the universe of corporations based on ownership of the corporation as:
- Public sector companies (or Public Sector Undertakings/PSUs)
- Private sector companies
Debentures issued by PSUs
PSUs issue both bonds and debentures. However, debenture issuances in the form of NCDs or Non-convertible Debentures are the highest among PSUs.
Debentures issued by private sector companies
Private sector companies issue debentures to fund projects. But very often the debentures issued by private sector companies are short-term (less than 5 years).
Types of debentures based on security
Based on security as the classification factor, we have two types of debentures:
- Secured debentures
- Unsecured debentures
Secured debentures are secured or backed by specific assets of the issuer as collateral. This security enhances the safety of the debenture. In case of default, debenture investors can take ownership of the collateral and sell it in the market to recover their money.
Unsecured debentures are not backed by collateral. This makes them slightly riskier than secured debentures as investors don’t have the same recourse to recover their money.
Types of debentures based on record keeping
Debentures may or may not require record-keeping when issued. Think of this like buying chocolate using cash at a store on the street versus depositing money in a bank. The general store doesn’t really record the particular transaction but the bank maintains the record and stores and distributes it.
Similarly, debentures are of two types:
- Registered debentures
- Bearer debentures
Registered debentures are those where the issuer keeps a record of the debenture holder’s details. The debenture holder must notify the issuer when he/she transfers the debenture to someone else.
Bearer debentures are simply distributed to investors without keeping record of who is buying them. Hence, bearer debentures are also sometimes called ‘unregistered debentures.’
Types of debentures based on coupon payment
Not all debentures pay coupons or interest. Hence, we can have two types of debentures based on coupon payment as the classification factor:
- Zero coupon debentures
- Coupon paying debentures
Zero coupon debentures
As the name suggests, zero coupon debentures don’t pay any coupons to the investor. Instead, these instruments offer all the profits on the maturity of the debenture.
Coupon paying debentures
Coupon paying debentures have a positive coupon rate or interest rate associated with them. The coupon payment that an investor will receive is determined by the coupon rate, the face and the payment frequency of the debenture.
Types of MLDs based on principal protection
MLDs or Market Linked Debentures have their returns linked to the performance of a market index or security price. Here’s an example to understand MLDs better:
Company A has issued a principal protected MLD (PP-MLD) that will return Rs. 110 for every Rs. 100 invested after 1 year. The condition for this return is that NIFTY 50 level after a year must be at 11,000 or above. If the condition is not met, the investor will only receive his initial investment.
MLDs are of two types based on principal protection:
- Principal-protected MLDs (PP-MLDs)
- Non-principal-protected MLDs
Principal-protected MLDs (PP-MLDs)
As the name suggests, principal protected MLDs return your principal even if the MLD condition is not met. Most MLDs issued in the Indian market are principal protected.
Non-principle MLDs are riskier than PP-MLDs because investors can lose not only their profit but also their entire investment.
Types of debentures based on convertibility to stock
Debentures are interesting instruments because they have the potential to convert into equity or shares of the issuing company.
Companies that don’t want to dilute equity issue non-convertible debentures and get the required capital. Companies that are comfortable with diluting equity in the future, issue convertible debentures that convert into equity in the future.
The conversion of debentures into shares/equity takes place when certain conditions are met or at a predefined point in future. Also, conversion into equity may not be applicable to all the debentures. Hence, there are 3 types of debentures depending on convertibility to stock:
- Non-convertible debentures (NCDs)
- Partially convertible debentures
- Fully convertible debentures
Non-convertible debentures (NCDs)
Non-convertible debentures cannot be converted into stock or shares of the issuing company partially or fully.
Partially convertible debentures
Partially convertible debentures can be converted into stock or shares of the issuing company but only partially. So, after conversion, the investor will have both debentures and shares of the company.
Fully convertible debentures
Fully convertible debentures fully convert into shares of the issuing company. After the conversion, debenture holders become shareholders of the company.
Types of debentures based on listing
Debentures that are listed on a stock exchange are bound by regulations in terms of disclosures and operations. But not all debentures are listed publicly on an exchange.
Debentures that are not listed can be traded OTC (over-the-counter) and require the services of a broker who will find a buyer for your bonds. OTC bond trading requires negotiation since there is no market price like listed bonds. Also, OTC trades are generally large in size because the buyers and sellers are HNIs and institutional investors, not retail investors.
- Listed debentures
- Unlisted debentures
Listed debentures are publicly listed and traded on a stock exchange. Because of market forces and given adequate liquidity, listed debentures are generally available for trade at a fair price. This works better for retail investors who don’t have the knowledge of valuing debentures.
Unlisted debentures are traded OTC (over-the-counter). It’s not a transparent market like a stock exchange and involves dealing with brokers who negotiate on your behalf for a fee.
Types of debentures based on redemption
Debentures can be redeemed before maturity. In India, this is true for all debentures because of regulations. However, debentures may not be available for redemption. Based on this, we have two types of debentures:
- Redeemable debentures
- Irredeemable debentures
Redeemable debentures can be redeemed at a future maturity date. On the maturity date, the investor receives the final interest payment and the initial investment made in the debenture.
Irredeemable debentures are debentures without a maturity date. In India, irredeemable debentures cannot be issued because of regulations. However, similar instruments called perpetual bonds exist in India and are mostly issued by financial institutions.