FINANCIAL PRODUCTS: DEBENTURES 1

Financial Product: Debentures

Navya Juneja 2023323, Nikhil Agarwal 2023324, Jayaganesh Jangam 2023382, Revanth Kumar
Ravipudi 2023383, Urjaa Mishra 2023380
Department of Business and Management, Christ University, Bangalore
BBAH 333: Indian Financial System
CIA 3
Dr Saravanan N
November 13, 2021
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Table of Contents

Meaning of Debentures ................................................................................................................... 4

Characteristics of Debentures...................................................................................................... 4

Nature of Debentures .................................................................................................................. 4

As Cash. ................................................................................................................................... 4

As Collateral Security .............................................................................................................. 5

As Consideration Other Than Cash ......................................................................................... 5

Categorisation of Debentures ...................................................................................................... 5

Based on Security .................................................................................................................... 5

Secured/Unsecured Debentures ........................................................................................... 5

Based on Convertability .......................................................................................................... 5

Convertible/Non-Convertible Debentures ........................................................................... 5

Based on Tenure ...................................................................................................................... 5

Redeemable/Irredeemable Debentures ................................................................................ 5

Based on Interest Rates............................................................................................................ 6

Specific/Zero Coupon Rate Debentures............................................................................... 6

Based on Registration .............................................................................................................. 6

Registered/Bearer Debentures ............................................................................................. 6

Advantages of Debentures .............................................................................................................. 6

Disadvantages of Debentures .......................................................................................................... 6

Conditions to be Met for the Issue of Debentures .......................................................................... 7

Process of Issue ............................................................................................................................... 7

Tax Implications ............................................................................................................................. 9

Factors to be Considered While Buying Debentures ...................................................................... 9

Debenture Redemption Reserve ................................................................................................... 10

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Application .................................................................................................................................... 10

Debentures & Deposits ................................................................................................................. 10

Case Study .................................................................................................................................... 11

Pros and Cons of the Situation .................................................................................................. 11

Suggestion to DHFL to Deal with the Situation More Efficiently ............................................ 12

Key Takeways from the Case.................................................................................................... 12

References………………………………………………………………………………………..13
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Meaning of Debentures

Companies can raise funds from both Equity and Debt. One of the most popular method of raising
debt fund is through debentures. Debentures can be understood as financial instruments that are
used by companies to raise long term debt from the public to fund their operations. It represents
the debt portion of the company’s capital structure, and the Debenture Holder becomes the creditor
of the company. The Debenture holders are paid a fixed interest rate by the company, irrespective
of them earning profits. It is not compulsory for the company to attach any collateral or physical
assets to back up the debt. The overall creditworthiness and reputation of the company suffice.

Characteristics of Debentures

● It is a part of the borrowed fund capital.

● The debenture holders are paid a fixed interest rate on the money they lent to the company.
● It is a written document that the company issues to the lender of the money. It is an
acknowledgement that the company has taken money from the lender and will repay the
money with interest on or before the bond's maturity period.
● The company issues the debentures under its common seal.
● It is a long source of finance, so the maturity period generally ranges from 10-20 years.
● These instrument carries no voting rights, and the debenture holders are mere creditors of
the company.
● During the winding up of the company, the debenture holders are paid their claim before
the preference and equity shareholders.

Nature of Debentures

Debentures are generally issued by companies to raise funds from the public, but it can also be
issued for various other purposes which describe their nature in that issue. A few of them are
mentioned below:

• As Cash: When the company issues debentures to raise funds from the public to finance
its operations. These are mainly used for cash. It can be issued as par, discount or premium,
all at the discretion of the company.
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• As Collateral Security: When the debentures are issued as additional security to obtain a
loan or overdraft facility from the bank or any other financial institutions, then the nature
of such debenture is collateral liability and is a contingent liability for the company. Such
liability will only arise when the company defaults on the repayment of such loans or its
interest.

• As Consideration Other Than Cash: This type of issue is done by companies when they
want to acquire some assets or machineries, plants, equipment which are huge in cost but
do not have enough capital at that very moment. So instead of paying the vendor in cash,
debentures are issued against such transactions.

Categorisation of Debentures

There are several types of debentures which a company can issue, depending on the purpose they
are issuing these for. These debentures are categorized under 5 broad categories, all these have
been discussed below:

Based on Security

Secured/Unsecured Debentures: When the debentures are secured by a mortgage or charge on the
company’s property, then these kind of debentures are secured while when debentures are not
backed with such security, it is termed as unsecured debentures.

Based on Convertability

Convertible/Non-Convertible Debentures: The debentures which can be converted into equity

shares on a specified date or on a certain event are called convertible debentures while debentures
which cannot be converted are termed as non-convertible debentures.

Based on Tenure

Redeemable/Irredeemable Debentures: Redeemable debentures are those which have a

predetermined maturity period and will expire on such date while an irredeemable debenture
cannot be redeemed and only interest is paid on such debentures till the debentures are cancelled
by the company or the event of winding up of the company.
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Based on Interest Rates

Specific/Zero Coupon Rate Debentures: Specific coupon rate debentures have a pre-mentioned
rate of interest and is known as the coupon rate while a zero-coupon rate debenture doesn’t
normally carry a coupon rate, instead such debentures are issued at a considerable discount and
the difference is treated as the amount of interest realated to the debenture tenure.

Based on Registration

Registered/Bearer Debentures: In a registered debenture, the details of the debenture holder are
kept in the Register of Debenture Holders with the company and transfer of such debentures
require a prior notice to the company, while a bearer debenture can be transferred to other person
by delivery of the bond and the company does not keep any record of the debenture holder. The
interest is paid to the person who has the interest coupon attached to such debentures.

Advantages of Debentures

Debentures have been a popular source of finance as the company gets the required funds without
diluting the equity of the company. The interest is charged against profit which means it is tax-
deductible expense which is useful while tax planning. Raising funds through debentures tend to
be cheaper than other forms of raising long term debt. The risk associated with such instruments
is very less as these debentures are secured and the interest is payable even if the company suffers
loss in that financial year. At the times of inflation, the debentures can be a preferred instrument
because of the fixed interest rate.

Disadvantages of Debentures

In spite the debentures are so popular, it has certain disadvantages. The interest payable is a burden
for the company as it must be paid even when the company is not performing well. Issuing
debentures makes the company dependent on debt, and a skewed debt-equity ratio is not healthy
for the financials of a company. The redemption of the debentures can be a huge cash outflow
making the liquidity of the company instable. Debentures can be very expensive during times of
recession as the profits are declining but the interest would be paid at the fixed rate.
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The entire mechanism of the debentures, how it is issued, how interest is paid and how it is
redeemed have been discussed in the next section of the paper.

Conditions to be Met for the Issue of Debentures

Companies Act, 2013, Section 2(30), has suggested certain conditions which need to be met before
the issue of debentures. Below-mentioned are the prerequisites.

● Although the secured debentures’ redemption should not exceed 10 years from the issue
date, the below mentioned classes of companies are permitted to issue debentures for than
10 years but not exceeding 30 years.
○ Companies dealing in and providing services to infrastructure projects.
○ “Infrastructure Finance Companies” as clarified by clause (viii) of direction 2 sub-
direction (1) of Non-Banking Financial Companies Prudential Norms (Reserve
Bank of India) Diections, 2007.
○ Infrastructure Debt Fund Non-Banking Financial Companies, specifically
described in clause (b) of Infrastructure Debt Fund Non-Banking Financial
Companies (Reserve Bank of India) Directions, 2011.
○ Companies that have been granted permission to issue debentures for a duration of
more than 10 years by a Central Government Ministry or Department, the Reserve
Bank of India, the National Housing Bank, or any other statutory body.
● The issue will be secured by a charge on the company's or its subsidiaries' or holding
company's or associates' properties or assets, with a value sufficient to cover the debentures'
principal and interest.
● Before the issue, a Debenture Trustee must be appointed to execute a debenture trust deed.
● The creation of a charge in the Debenture Trustee's favour is done prior to the issue.

Process of Issue

● Holding a Board Meeting - A firm must conduct a Board Meeting to consider and adopt
resolutions for the following items: Debenture Issue, Offer Letter Approval, Private
Placement of Shares Approval, Debenture Subscription Agreement, Bank Account
Opening, and EGM Calling (Extraordinary General Meeting).
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● Organizing an Extraordinary General Meeting - The firm must additionally hold an

EGM (Extraordinary General Meeting) to debate and vote on the following extraordinary
resolutions:
- Increase in the company's borrowing capacity
- Issuance of non-convertible debt.
● MGT-14 to be filed with ROC - Within thirty days of passing the Special Resolution, the
corporation must file MGT-14 with the ROC (Registrar of Companies).
● Maximum Capacity - In any given fiscal year, the corporation must limit the number of
investors who receive the offer letter to no more than 200.
● Size of the Investment - Each investor's investment should not be less than Rs. 20,000.
● Letter of Acceptance - The firm must send the investors a letter of offer and create a bank
account.
● File a letter of offer with the ROC - The offer letter, as well as Form GNL-2, PAS 4, and
PAS 5, must be filed with the ROC by the company's directors.
● Obtaining Funds from Investors - Following that, the directors gather application money
from investors for the issuance of debentures.
● Board of Directors Meeting - Following the close of the offer, the firm will need to have
another board meeting to examine the following agendas:
- To distribute its debentures within sixty days after receiving the application money.
- To ratify the charge-creation agreement.
- To provide final approval to the debenture trust deed.
● Filing CHG-9 - The corporation must file Form CHG-9 with the ROC within thirty days
of placing a charge on assets (Registrar of Companies).
● Restrictions on Using the Application Money - The funds collected by the issuer
corporation cannot be used until all of the investors have received their debentures.
● Filling Return of Allotment - Within fifteen days following allotment, the issuer
company's director must file a Return of Allotment in Form PAS 3 with the Registrar of
Companies.
● Submission of the Corporate Action Form - Within two working days following
allotment, the issuer corporation must file its Corporate Action.
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Tax Implications

● If one maintain debentures until they mature, the returns are combined with their income
and taxed according to their tax bracket.
● If one sells their debenture on the stock exchange before the year is up, they are bound to
pay the short-term capital gains tax as per their tax bracket.
● If they sell their debenture before it matures after a year, they will have to pay a long-term
capital gain of 20% plus indexation.

Factors to be Considered While Buying Debentures

● Anticipated risk and return capacity

Any investor should conduct a self-assessment of the risks involved before making any
investment choice. Determine your risk tolerance, and then devise an investing plan based
on it, taking into account your total objective return on investment as well as the possible
cost of risk. When determining whether to invest in high-yield bonds, investment-grade
bonds, government bonds, or a combination of the three, this is critical.

● Maturity date and investment horizon

Investors should select debentures based on the estimated return date and their investment
horizon, or the length of time they want to retain their investment. They must compare this
to the maturity date of the debentures they're considering investing in and make their
decision based on that information.

● Bond-issuer’s buy-back option

Another distinctive feature of bonds is the buy-back option included in some issuers' bond
investment conditions. As a result of market performance or lowering interest rates, the
issuer might redeem the debentures before the maturity date. When picking bonds to invest
in, an investor must consider this factor.

● Debt Obligations of Bond Issuer

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Debentures are loans issued by firms, therefore investors are technically giving money to
the bond issuer. As a result, you should assess the issuer in the same way you would any
other borrower. The issuer should be able to deliver on its promises to refund the principal
and interest. Investors must follow the issuing company's past, current, and prospective
financial performance in order to assess this.

● If the bond is secured

Checking if debentures are secured or unsecured is one of the most significant elements to
consider while investing in them. If the firm defaults or declares bankruptcy, this decides
whether you will receive your money back.

Debenture Redemption Reserve

A debenture redemption reserve (DRR) requires every Indian business issuing debentures to
establish a debenture redemption service in order to safeguard investors against a corporate default.
In the 2000’s ammendment, this clause was added to the Indian Companies Act of 1956.

Application

A debenture allows investors to borrow money at a specific rate of interest. Because there is no
asset, lien, or other kind of security backing this instrument, it is classified as unsecured.

As a result, Section 117C of the Indian Companies Act of 1956 established the debenture
redemption reserve (DRR) obligation to safeguard debenture holders from the danger of issuing
company default. This mandate compels corporations to set aside a particular proportion of the
amount collected via the debenture issuance in cash in a special fund that will only be utilised to
settle their debt obligation in severe instances rather than defaulting on the debenture.

Debentures & Deposits

As per the Companies (Acceptance of Deposit) Rules 2014 , certain debentures are not treated as
deposits:-
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● Secured debentures by first charge (here the assets charged shall be tangible assets of the
company referred in Schedule III of the Companies Act, 2013)
● Debentures which are compulsorily converted into equity after 10 years.
● Unsecured Non-Convertible Debentures and listed on recognized stock exchange

All other types of Debentures are considered as deposit and same needs to be filed every year in
Form DPT-3 by the Company.

Case Study

Debentures provide a profitable interest rate, but they also carry a certain element of risk. In the
instance of Dewan Housing Finance Ltd, this was witnessed in 2016. DHFL's debentures were
accorded a AAA rating by CARE (Credit Analysis and Research Limited). In 2019, the firm began
to fall behind on its payments. CARE unexpectedly reduced them to default status (D). All of this
took place over three months.

DHFL was being acquired by Piramal Enterprises Ltd and being converted into PCHFL. During
this resolution, DHFL decided to replace their 9% non-convertible secured Debentures to 1%
unsecured bonds under the newly formed PCHFL. The replaced bonds had a 20 year maturity
period and 1% coupon rate. Many DHFL debenture holders suffered significant losses as a result
of this.

Pros and Cons of the Situation

Pros - DHFL is a company which is about to bankrupt. So, when one demands for repayment of
the outstanding money, they will receive much smaller number of returns. So, receiving debentures
from a bigger and successful company (Piramal), may give them a chance to reclaim the losses.

Cons - Replacing a secured NCD with an unsecured NCD can lead to be easily written off by the
acquiring company like it was done by Yes Bank and LVB Bank situations. So, this decision
should have been taken only when it was approved by the debenture holders.
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Suggestion to DHFL to Deal with the Situation More Efficiently

● Before taking the decision which constitutes a material event, DHFL should have called
for a debenture holder meeting to explain the investors the proposal and seek their approval.
● Also providing part cash and partly by way of debentures issued by Piramal in demat form
in the names of the holders would have also worked, so the holders could have got the
money they waited for the capital they invested in DHFL and some securities for the future.

Key Takeways from the Case

● One must not only examine the credit rating but also assess the issuer's credibility.
● This may be accomplished by simply reviewing the company's balance sheet and analysing
the cash flow statement.
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References

Corporate Finance Institute. (2020, May 25). Debenture.

https://corporatefinanceinstitute.com/resources/knowledge/finance/debenture-bonds/

Mendonsa, C. (2021, October 4). What are Debentures? - Types, Advantages and Bond vs

Debenture. Samco - Stock Market Library - Learn Everything about the Indian Stock

Markets. https://www.samco.in/knowledge-center/articles/what-are-debentures/

Pathak, B. (2020). Indian Financial System (4th ed.). Pearson India Education.

TaxGuru Consultancy & Online Publication LLP. (2021, September 29). All about Debentures

under Companies Act, 2013. TaxGuru. https://taxguru.in/income-tax/debentures-

companies-act-2013.html
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