Return On Investment In Debentures: With several options available nowadays for making investments, investors can choose asset classes according to their risk appetite.
More or less, asset classes have been divided into categories such as stocks or equities, bonds or some other fixed-income investments, cash or cash equivalents (money market funds), real estate, forex, futures, and other derivatives, etc.
While investing in equities is considered a risky investment by several individuals, we cannot ignore the fact the returns provided by these asset classes outweigh the risks involved. Some people tend to invest in fixed-income securities such as bonds, debentures, etc.
Debentures are favoured by individuals having lower risk appetites. Debentures are considered long-term financial instruments issued for specified tenures with a promise to pay fixed interest.
In this article, we will delve deep into the definition of debentures. We will also talk about the return on investment in debentures and what category of investors prefer to choose this asset class. Read on!
Debentures – What Are They?
A debenture is a type of long-term business debt which is unsecured by any collateral. Simply put, this is a funding option for companies having strong finances who want to avoid issuing shares which ultimately leads to equity dilution. Most of the time, debentures are preferred by companies that don’t want to tie up assets or who lack collateral for a conventional loan.
In the simplest form, a debenture can be understood as a legal certificate stating how much money the investor gave (known as the principal), the interest rate to be paid, and the schedule of payments. Investors tend to receive their principal back at the maturity of the debenture (i.e., at the end of its term).
Therefore, the business is liable only for interest payments (a percentage of the face value of the certificate, or loan amount) during the loan period. Upon the maturity of the certificate, the business repays the full principal (the loan amount).
From the point of view of security, debentures are classified as secured debentures and unsecured debentures. Secured debentures means those debentures where a charge is being established on the properties or assets of the enterprise for payment purposes.
The charge can be either floating or fixed. On the other hand, unsecured debentures do not have a particular charge on the enterprise’s assets. However, a floating charge can be established on these debentures by default. Usually, such debentures are not circulated.
Factors To Be Considered Before Making Investments In Debentures
Investing in debentures is much simpler than investing in equities as there is a defined maturity. The issuer of the debt instrument makes a commitment to pay back the invested amount on a specified date. In equities, there is no maturity. Investors are required to sell their securities in the secondary market when they need to.
Since investors are dependent on the debenture issuer for the payments, the creditworthiness of the issuer is of paramount importance. However, it is possible to sell a debenture in the secondary market before maturity.
If any deterioration is seen in the quality of the issuer, the purchaser will consequently be willing to pay a lower price. Therefore, it is advised to check the creditworthiness of the bond-issuing company.
Professional and institutional investors including fund managers or corporate treasury managers prefer to conduct their own research about the quality of the issuer. However, every investor will not have the bandwidth to do so.
Next, investors should also look for potential exit options before making any investments. They need to consider their liquidity requirement before making any investment to match the investment horizon with the maturity period, which is generally 5-10 years. Premature selling can expose investors to volatility in interest rates.
If investors plan to exit their investment before the maturity period, they need to check for liquidity. Investors are also required to check the company’s debt levels, capital adequacy ratio, interest coverage ratio, etc. before making investments in their debentures.
Return On Investment In Debentures
There is no thumb rule which decides the exact return on investment in debentures. However, investors can compare instruments with a similar rating in the market to ascertain a reasonable figure.
Return on debentures can also depend on the industry in which the company operates. Apart from this, the market’s attitude is also important. For example, a finance entity will offer a higher rate on its debentures than a manufacturing company.
This is because the market is more comfortable in making investments in manufacturing companies and they will buy debentures even at a lower yield than those of finance entities.
Return on investment in debentures is defined when at the time of purchasing it. There is always demand for good-rated investment products having the ability to offer attractive returns.
Keeping this in mind, companies continue to come up with debenture issues to raise capital from the market. In the current scenario, investment in debentures has become more important for investors as the share market has become quite volatile due to several factors including inflation.
Making an investment in debentures is better than making an investment in fixed deposits as return on investment in debentures is better in comparison to the latter. Interest differential is quite significant.
Debentures tend to offer 2-3 percentage points more in interest against bank fixed deposits for a slight increase in risk. Return on investment in debentures ranges from 7% to 10% if held till maturity.
Interest payments in debentures are made either monthly, quarterly, half-yearly, or annually. Moreover, unsecured NCDs can offer a higher interest rate.
Debentures are vulnerable to risks related to business and funding. Therefore, credit rating can take a hit if any impact on turnover is seen. The company might have to borrow some additional funds from banks or NBFCs to counterbalance the impact.
Thus, investors should always do a background check before making these investments. Investment in NCDs carry a lesser amount of risk as only companies having good credit rating can issue secured NCDs.
Apart from this, NCD investments help in adding diversification to an investor’s portfolio with income security. NCD investments also carry the benefit of good liquidity as these can be sold on stock exchanges.
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