What is a Debenture?

A debenture is a private and long-term debt instrument issued by financial, non-financial institutions, governments, or corporations. A debenture is classified as a type of bond, where the instrument carries a fixed rate of interest, commonly known as the ‘coupon rate.’ Debentures are documented in an indenture, clearly specifying the type of debenture, the rate and method of interest computation, and maturity date.

Debentures are generally unbacked by any collateral and depend exclusively on the financial merit and credibility of the issuing corporation. As opposed to loans and other forms of debt instruments, debentures carry longer repayment schedules coupled with lower interest rates, thus being extremely beneficial to the issuing corporation.

Why are Debentures important in the Capital Market?

Debentures are a primary segment of the capital market. It is important to understand its applications in the corporate world, especially since it heavily relies on the issuer’s financial strength. Debenture holders do not have voting rights. Debentures are listed in the balance sheet under “Long Term Borrowings.” Hence, in the event of bankruptcy, debenture holders are paid before equity shareholders.

Types and Categories of Debentures

To understand the valuation of debentures, we will first understand the different types of debentures. They are broadly classified into the following categories:

Secured and Unsecured debentures

• Secured debentures are simply the debentures secured by an asset are those secured. This charge may be a fixed (a mortgage on specific assets which cannot be sold without the express consent of the debenture holders) or a floating charge (which may cover all existing and future assets of the company).
• Unsecured debentures arenot secured by any charge on any asset.

Convertible and Non-convertible debentures

• Convertible debentures are those that could be converted into equity shares (at par or premium) after a certain period from the date of its issue. They may also be partly or fully convertible. Convertible debentures do not have any primary collateral and are unsecured loans.
• Non-convertible debentures are those that cannot be converted into equity (shares) in the future.

Redeemable and Irredeemable debentures

• Redeemable debentures are repayableafter a certain period, as documented in the indenture.
• Irredeemable debentures are the perpetual debentures that are not repayable while the evaluated time of the firm.

How is the Value of a Bond Calculated? 

Bond valuation (including that of a debenture) is understanding and determining the fair price of the bond. The value of the bond can be computed by a simple formula which is the sum of present values of all the coupon payments and the final redemption amount, discounted at the required rate of return. Let us understand the important components of the indenture:

Loan amount: The “principal,” “face amount,” or “par value” represents the amount that the bond issuer agrees to pay at the maturity of the corporate bond. This is one of the most important components in bond valuation, as it represents the original cost of the stock, which is the key to determining the stock valuation at maturity.

Coupon/Interest rate: The coupon rate is fixed based on market conditions, but once fixed, it is applicable for the entire bond life. The amount of interest can be computed by multiplying the interest rate with the loan amount.

Interest schedule: The frequency of interest payments is usually in intervals of 6 months (bi-annually)

Term: The bond’s maturity is the length of the time until the principal amount is repaid. A debenture is a long-term debt instrument, usually with a term of five years or greater.

Call: The call option in the indenture protects the bond issuer by allowing them to “call in” the bonds and repay them at a predetermined price before maturity.

Understanding the Computation of Bond Valuation

The Yield-To-Maturity (YTM) is the most common method for computing yield. YTM is the total return expected on a bond if it is held until the time it matures. This is effectively a computation of the Internal Rate of Return (IRR) where the bondholder holds the bond till maturity and then reinvests at the same rate. YTM is computed to determine the performance of different debt securities and used to compare one against the other to make qualitative decisions.

 Using the YTM rate computed above, the bond can be valued using the following formula:

$$\text{Price of Bond}=\frac{\text{Coupon 1}}{{\left(\text{1+ YTM}\right)}^1}+\frac{\text{Coupon 2}}{{\left(\text{1+ YTM}\right)}^2}+\frac{\text{Coupon 3}}{{\left(\text{1+ YTM}\right)}^3}\mathrm{.....}+\frac{\text{Face Value}}{{\left(\text{1+ YTM}\right)}^n}$$

The present value of the discounted cash flows can be computed to arrive at the bond value. It is important to understand the present value of future income for the investor to understand if he or she will effectively make any gains from investing in these debentures or bonds.

While the above formula can be used to compute the value of the bond with a fixed maturity period, there may be some rare forms of debentures where the bond is in perpetuity. The formula may remain the same, but the value of the perpetual bond will be the discounted sum of the infinite series.

Bond Valuation Computation with an example

Let us understand the stock valuation of a debenture with the help of an example:

The face value of a debenture is $100 with a maturity value of $100. The coupon rate for this bond is 8% payable semi-annually. If the Yield to Maturity is 9%, and the bond will mature in 5 years from today, what is the value of the bond?

$$\begin{array}{l}InterestforYear1to10\left(sincethecouponpaymentsarepayablesemi-annually\right)=\$4\hfill \\ n=10\left(5yearsxhalf-yearlypayments\right)\hfill \\ YieldtoMaturity=9\%;semi-annually=4.5\%\hfill \end{array}$$

Solving for the bond value using the formula, we get the bond value as $96.04 (rounded off at two decimal places)

The above is by using the present value factor for the rate of interest. Under the discounted cash flow method, the value of a bond can be calculated as follows. Note that in this method of present value computation, every year, the interest will be calculated on the difference between the Loan amount outstanding and the Principal payment required to be made every year. For example, if the loan amount is $1000 with a tenure of 5 years, carrying an interest rate of 12%, then the following will be the interest computation:

Common Mistakes and Pitfalls

Some of the common possible errors while computing the debenture value are as follows:

• Using the incorrect formula while computing the Yield To Maturity or the Internal Rate of Return. This may lead to substantial errors in the calculation of the value of a bond.
• Making errors in calculation, especially in making present value computations or in determining the value of the bond.

Context and Application

This topic is significant in professional exams in graduate and postgraduate courses, especially for:

• Bachelor of Commerce
• Master of Commerce
• Chartered Accountants
• Company Secretary