What is a bearer debenture? How does it work? In this article we shall take a look at debentures in general and the various aspects of bearer debentures specifically.
Overview
The financial market is unlike any other kind of market in the world. Its commodities are complicated. It requires a buyer to study the market, its past and present trends, and the terms and conditions of owning the commodity as well. It is one of those rare markets where if the buyer is smart enough, he can ensure that the value of his or her purchase appreciates rather than depreciates. This is because commodities sold in the financial market are financial instruments. And unlike any other commodity, these commodities have no actual application or utility to the buyer. It is purely an investment that is made with the hope of seeing some growth. The most common financial commodities in this market are shares and debentures (Bearer Debentures).
Debenture Definition
Debentures are debt instruments, as the name suggests. This means that the money raised from sale of debentures is considered to be a debt or a loan for the company that is selling these debentures. Debentures usually come with a fixed rate of interest. In its tangible form it is a certificate that states the basic details of the transaction such as the name of the owner or the ‘debenture holder’, the value and quantity of debentures owned by the holder, the date of issue of the debentures and the date on which the debentures will be redeemed in case the debenture is a redeemable debenture. There are many types of debentures, each type having a unique and distinguishing feature depending on the needs of the company selling the instrument and the demand for the instrument in the market.
In this article we will focus on understanding Bearer debentures and how they are different from other debentures. However it must be noted here that bearer debentures have now mostly been prohibited in most countries as they increasingly began to be used to launder money and evade taxes.
Let us now look at the various types of debentures.
Types Of Debentures
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Convertible And Non-Convertible Debentures
Debentures, like most loans, usually have a term period. No company wants to be bonded in debt perpetually. So most companies pay back the money raised from issuing debentures in one way or another. This is the part that is unique to this type of debenture, i.e., the manner of its redemption. Convertible bonds are bonds that are redeemed by converting it into some other form of financial asset such as shares. This means that on the date of redemption, the debenture holder will be issued shares or any other financial instrument to the tune of the value of the debentures. Debentures and shares don’t need to have the same parity value. After all, shares come with voting rights and a longer lifetime. So the conversion is done based on the market value of the debenture vs the market value of the share instead of a simple one-to-one ratio in terms of quantity. Non-convertible debentures are those debentures that cannot be converted to other financial instruments and are redeemed in cash payouts.
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Preferred And Ordinary Debentures
A company can issue multiple categories of financial instruments to fund its endeavors. A company can choose to finance its projects partly by issuing debt instruments and partly by issuing equity instruments such as shares. This is at the discretion of the company. Many companies also have subcategories within one category of instruments as well. This type of debenture is a classic example of this kind of debenture with subcategories. Preferred and non-preferred debentures on the face of it might look more or less the same with differences, if any, arising in the form of purchasing rate and interest rate. But holders of preference dividends, as the name suggests, hold a preference over holders of ordinary debentures when it comes to redemption. When an issue of debentures is well planned and its redemption is executed smoothly, then the difference may go unseen.
But the difference becomes very evident when a company is unable to pay back its debenture holders or has wound up operations and is being liquidated on bankruptcy. In such a scenario, all the money raised from the liquidation of the company’s assets is used to pay off the company’s debts. And here there is an order that takes precedence. The money is first used to pay off debenture holders over shareholders as their money is considered to be a loan. And even within debenture holders, preference debenture holders are given the first preference when it comes to redemption. This means that their money will be paid back as the highest priority over others. In short, preference debentures are more secure and more dependable in terms of returns on investment although it may not be the highest return on investment. The risk factor is very low amongst other financial instruments when it comes to preference debentures.
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Registered Debentures And Bearer Debentures
This type of debenture distinguishes itself from other forms of debentures in terms of ownership and ease of transfer. Registered debentures are debentures where the company keeps track of the debenture holders by archiving the details of the debenture holders in their registers and keeping them as such for redemption. This means that the owner and the company are bound in a debt-based relationship and require a mutual agreement for the dissolution or transfer of such relationship. This means that the owner of registered debentures has to inform the company that has issued the debentures if he or she wishes to sell or transfer his or her share of debentures to another party and the company is required to update the records accordingly. The owner of the debentures as per the records of the company is the only one who is entitled to redeem the debentures on the expiry of its term.
Bearer debentures, on the other hand, can be transferred by mere delivery and hence, are payable to the bearer of the instrument. No records are maintained in the register of debenture holders and registration of transfer is not necessary. That is why they are also known as unregistered debentures.
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Secured Debentures And Unsecured Debentures
Secured debentures get their name since these debentures have a charge or collateral attached to them in the form of an asset of a company. To further explain, in case the company doesn’t have any funds to pay the secured debenture holders, then, the company will sell the said asset to pay such a loan. The charge may either be a fixed charge, i.e., against a specific asset/s or a floating charge, i.e., against all the assets of the company.
Unsecured debentures or naked debentures, do not have any fixed or floating charge attached to them in the form of assets of the company. This means that in the event of the company winding up or finds itself unable to repay the debenture holders then unsecured debenture holders will have to get in line behind secured debenture holders and redeem whatever remains after the other secured creditors of the company have been paid off. The buying rates of such debentures are usually low although the rate of interest may be rather high as can be seen even in the case of unsecured loans which come with an alarmingly high rate of interest.
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Redeemable Debentures And Irredeemable Debentures
Redeemable debentures are debentures with a fixed term period. This means that the company issuing the debentures has very specific plans with the funding it wants to raise by issuing debentures and intends to repay the entire amount to the debenture holders before the expiry of the term. These debentures can be redeemed at par, premium or at a discount depending on the terms in the issue document.
On the contrary, irredeemable debentures cannot be redeemed during the lifetime of the company. Also known as perpetual debentures, these are repayable at the time of liquidation or after an unspecified time interval which may be at the whim of the company.
Bearer Debentures
Now that we have a fair idea about the types of debentures, let us throw some light on bearer debentures in specific.
Features And Benefits Of Bearer Debentures
- Bearer debentures are unregistered debentures that can be transferred by mere delivery. No records are maintained in the company’s debenture holders register for the ownership of these securities.
- Such debentures are issued physically, i.e., on paper.
- To receive interest payments, the bondholder needs to submit the coupons for interest payment which are physically attached to the security to the bank or the issuing company.
- These debentures can be redeemed within thirty days from the date of maturity which is printed on the bond.
- Selling bearer debentures is relatively easy as no third party or intermediary is needed since these can be simply transferred by just handing over the certificate to the other person.
Risks Involved In Purchasing Bearer Debentures
Even though there are many benefits attached to the purchase of bearer debentures, the risks involved cannot be ignored.
- Since the sale of these securities is not recorded by the issuing company, replacement in case of a lost or a stolen debenture is not possible. Any person who finds it will be considered the owner as these debentures can change ownership by mere delivery.
- Likewise, since no information is printed on this type of bond, the person in possession of the bond can claim the final payment.
- In case of any rise in the interest rates, the issuing company is under no obligation and can call back the bearer debentures anytime.
- There is always a risk of losing the interest payment coupons if these are detached and sent through the mail. So, the bond needs to be delivered to a bank in person to redeem it at the time of maturity.
- In case of death of the bearer debenture holder before the date of maturity, it becomes nearly impossible to claim the principal and interest payments.
- Apart from the risks involved mentioned above, there is another very important factor that has prompted many economies to stop the issue of these bonds. The bearer bonds can be easily used for money laundering or tax evasion as owners of bearer bonds are able not to report any profits that come from holding this type of bond.
Conclusion
Issuing debentures as a method of raising funds is something that is highly regulated, especially because it is an instrument of debt and not equity. An equity instrument comes with its risks and rewards. The owner of an equity instrument cannot force the company to pay returns or dividends on investment. Debentures are a different case altogether. Most debentures come with a legally binding promise to not only pay back the amount borrowed on issue of debentures but also the promise to pay a fixed periodical interest on that amount and this promise is enforceable by the law.
If the issuer of debentures fails to pay the interest or the principal without the permission of the debenture holder can be held liable in a court of law and can lead to liquidation of assets and even imprisonment. All these factors make debentures a low yield but also a low-risk investment for people who are just looking to utilise their unused or surplus funds. If you have any other query with regards to debentures or any other financial and regulatory matters, do get in touch with us with your query and we will ensure that it is attended to by our team of legal experts who will guide you with your questions and assist you with your needs.
