Debentures are a loan that a company takes for the sake of expansion or development. Debentures are a significant part of the securities market. In the last few years, we have seen a lot of banks issue debentures here in Nepal.
From this article, you will able to learn the following :
- What are debentures? And how do they differ from bonds?
- How are they issued and who issues them and the reason behind it
- Why debentures are safer investments compared to stocks
- Risks associated with debentures
- How can the value of debentures change
What debentures are? and how do they differ from bonds?
A company raises capital in two significant ways. Either by Issuing stocks (IPO or FPO) or by Issuing Debentures(Taking a loan). A debenture is simply a document by a company committing to pay a fixed interest for a fixed amount of time to whoever is the holder. After the maturity period (usually 7-10 Years), the principal amount given by the investor at the beginning is given back to the investor after maturity (when the debenture contract expires). The contract simply says that the debenture holder is due a fixed interest on his investments (Loan given to the company) every year (Also called a coupon). In Nepal, we see that the par value of most of the debentures issued is Rs. 1000 and the interest ranges between 9-10.5% annually.
E.g., let us assume a company issues a debenture at 10% for the next ten years(Maturity Period). It is to say that you, as a debenture holder, will be viable to get a 10% interest on your investments every year for the next ten years.
Bonds and debentures are similar to each other in that governments generally issue bonds while companies issue debentures. In Nepal, the general public cannot invest in government bonds. Hence, I am not going to talk about it here in detail. Compared to other developed countries out country does not have a lot of investment products and we are stuck with the ones we have.
How are they issued, who issues them and the reason behind it
To understand this idea, let us look at a hypothetical example. Let’s say Nepal Investment Bank wants to expand its branches and adopt new technologies. All of this development will require a lot of capital. Hence they raise funds by issuing bonds. But why issue bonds and collect money from millions of people when they can simply take a loan? This is because, with bonds, they can control the interest rate. This allows them to calculate their risk for the foreseeable future and manage it. So the bank will issue a bond promising a consistent return for the next 7-10 years. Companies also issue debenture because they are tax-deductible. i.e., to say that companies can show debenture as expenses to defer taxes.
What will happen if you buy the debenture? Let’s say you buy a debenture which promises to give a 10% return at a par value of 1000 for the next ten years. Then you can expect to make Rs 100 every year for the next ten years. In the end, you will make a total of 1000 Rs as a total return in the next ten years. At the end of the ten years, you will also get the cash you initially invested (i.e., 1000 Rs).
Why debentures are safer investments compared to stocks
Debentures are considered safer investment vehicles compared to stocks because their value cannot be as easily manipulated as that of stocks. More often then not, the companies which issue debentures are massive companies with a substantial reputation. Debeutre holders are the first to get their interest before dividends are paid out to the preferred and common shareholders.
Also, debenture holders will get the promised interest (e.g., 10%) every year regardless of how the company is doing financially. If a company is at a loss, it still has to pay 10% to the debenture holders. Whereas in the case of stocks, if a company is going through a rough period, it can choose not to pay any bonuses or dividends to its shareholders. Because of the consistent return with little to no fluctuation in value, debentures are considered a lot safer investments than stocks.
There is a caveat, though. If a company makes a profit, then it’s the shareholders that mostly reap the benefit from that profit. This is because the interest paid out to the debenture holders remains constant even if a company is doing exceptionally well. Hence if you are conservative with your money, debentures are the better option for you. I, on the other hand, am young and can take on a lot of risks because of which I see no benefit in debentures. If I want a safe investment, I can just put my money in fixed deposits, which In Nepal gives me a similar return. But you may be in a different situation and think differently. Hence self-awareness is critical when it comes to investment in securities (stocks or debentures).
Risks associated with debentures
As with anything, nothing can be risk-free. There are a few risks related to debentures. Although, in the case of Nepal, these risks are non-existent. Although it has to be pointed out that the debenture market in Nepal is still at its infancy.
The first risk is that the company which issued the debenture may fail to pay the interest. That is to say that the company could collapse. Collapse is highly unlikely as most of the companies that issue debentures in Nepal are massive companies that are not going to collapse any time soon. And in the worst-case scenario, if a company does collapse, its resources are sold. (Equity) After which the first payment from the sale is made to the debenture holders before anyone else. Therefore by investing in big companies with a good reputation, the risk of owning a debenture can be substantially lowered.
The second risk is the change in interest rate. This is also not a huge problem in Nepal as debentures, on average, give a return of 9-10.5 %. In countries like the US, the interest rate fluctuates a lot. Interest rates are changed primarily to stimulate or destimulate an economy. You can learn all about how interest rates influence the market in my earlier article, where I have written about how the economic machine works.
The third risk is the inflation rate. This is to say that if the inflation rate is 11% and you are getting a 10% return, then you will lose 1% of the money you invested. I have discussed how inflation can eat away at your profit in the financial freedom article I wrote for share Sansar.
All of these are the risks associated with owning a debenture. If you are betting that the economy will do better in the long run, then you have nothing to worry about. Or else everything collapses. In which case, we are all fucked.
How can the value of debentures change
Debentures are traded in the Nepalese securities market, but they are not as commonly traded like stocks. There are two ways in which the value of a debenture can change. One is at the level of the market and another on an individual level.
At the level of the market
E.g., let’s say you currently hold a debenture with fixed interest at 9%. And Let’s jump into the future and assume that after two years, people can buy debentures at fixed interest rates of 10%. In this case, the value of your debenture decreases as people can easily buy a 10% debenture in the market. And the opposite is true as well i.e., if, after two years, people can only purchase debentures at a fixed rate of say 8%, then the value of your debenture increases. In a future post, I will discuss how these values can be calculated mathematically.
On an individual level
This idea is very straight forward, and I want to use my personal experience to describe it. For the last five years, my stock investments have resulted in an overall return of about 15%. Although I have to admit that most of that return is unrealized. But as I said above, I am very young, and I can take on a lot of risks. Hence on an individual level, debentures are not valuable to me. As I said earlier, if I want a consistent return, I can just keep my money in fixed deposits where I can still get about a 10% return on my investment. So unless there is a gap between fixed deposits interests and debenture interests. I am not going to opt into investing in debentures anytime soon. But if you are an older gentleman reading this (Above the age of 40), I would advise you to take the safer route and invest in debentures and mutual funds (A topic I will discuss in a future post).
- Debentures are loans taken by a company from the general public for development or expansion.
- In return, the company commits to pay a fixed amount of interest annually to the debenture holder.
- Companies issue debentures instead of taking loans because they can control interest rates for an extended period. Hence they can calculate and manage risks.
- Debentures are safer investment vehicles compared to stocks.
- There is minimal risk associated with debentures.
- The value of debentures fluctuates less compared to stocks.
Last articles on Value Investing
For more research: you should check out https://www.theinvestorspodcast.com/ as I am sharing the ideas I learned from his videos