Companies that have issued debentures keep a fund called the Debenture Redemption Reserve (DRR). Its goal is to keep the danger of debenture default to a minimum. The DRR guarantees that funds are available to meet debenture holder commitments. There are two parts to the DRR. Setting away a percentage of the profit is the first step.
What Is a Debenture Redemption Reserve?
The process of allocating profit is known as the “earmarking of funds.” It guarantees that sufficient earnings will be accessible to repay the debentures. The second part entails a financial investment. It assures that the company has sufficient liquidity to repay the loan.
A debenture is a type of financial product that allows investors to borrow money at a fixed rate of interest. Because there is no asset, lien, or other kinds of collateral backing this instrument, it is classified as unsecured.
A debenture redemption reserve (DRR) is a regulation that requires every Indian corporation that issues debentures to establish a debenture redemption service in order to protect investors against a company failure. In an amendment proposed in the year 2000, this provision was added to the Indian Companies Act of 1956.
India’s Ministry of Corporate Affairs has amended the rule over the years to suit new DRR standards. The reserve criteria were initially set at 50% in March 2014 but were soon reduced to 25% in April 2014. They were reduced to 10% of the existing debentures’ value beginning in 2019.
The creation of a DRR was a necessity for all businesses. The Ministry of Corporate Affairs (MCA) published a notification about DRRs on August 16, 2019. The requirement for corporations to keep a DRR has been eased as a result of the notification. Companies listed on the National Stock Exchange (NSE), Bombay Stock Exchange (BSE), or Calcutta Stock Exchange (CSE) do not require to keep a DRR as of August 16, 2019.
Example of a Debenture Redemption Reserve
Assume that on January 10, 2021, a corporation issued $10 million in debentures with a maturity date of December 31, 2025. In this situation, a $1 million debenture redemption reserve (10% x $10 million) must be established before the debenture’s maturity date.
Companies who do not establish such reserves within 12 months of issuing the debentures will be obliged to pay debenture holders 2 percent interest as a penalty. Companies, on the other hand, are not required to fund the reserve account with a single significant deposit right away. Rather, they can credit the account with enough money every year to meet the 10% threshold.
Companies also must reserve or deposit at less than 15% of the value of their debentures set to expire on March 31 of the following year before April 30 of each year. This money that can either be put in a planned bank or invested in business and government bonds is for payment of interest or principal payments on year-end debentures and cannot be used for any other reason.
Debenture redemption reserves must only be established for the non-convertible portion of partially convertible debentures. For any other reason than debentures, a firm cannot use cash assigned to the DRR.
Why is it important?
Your investments in NCDs are likely to be riskier with no DRR support on debenture issues (excluding non-listed)/NBFCs or HFCs. In addition, RBI and the center also intend to better monitor NBFC/HFC liquidity positions so that they are alerted early to potential defaults. However, the absence of a DRR makes NCDs more dangerous, especially those that are unprotected. The change can thus have a detrimental medium to long-term impact on debt investors.
Components of Debenture Redemption Reserve
DRR is made up of two parts. Setting away a percentage of the profit is the first step. The process of earmarking money is used to allocate profits. It guarantees that sufficient profits are available for debt repayment. The investment of funds is the second component. It guarantees that the corporation has sufficient liquidity to meet its obligations.
Uniqueness and Purpose of Debenture Redemption Reserve
A DRR guarantees that a business sets aside a percentage of its income to repay long-term NCDs from current profits. When a corporation that has issued NCDs goes bankrupt or runs out of cash, it frequently fails on its loan repayments.
In these circumstances, the presence of the DRR minimizes the buyer’s investment risk. While most corporations issue secured debentures (using the company’s assets as security), a DRR can also assist, as it can take a significant length of time to collect dues via liquidating properties.
Companies that loan the money via debentures may not have the money to reimburse. The Government developed the DRR idea in 2000, intending to minimize the likelihood of failure. A lack of profitability and liquidity are the main causes for the failure. The idea of a DRR sets two requirements to overcome both these issues:
- A share of the profit is ‘marked’ each year for distribution to the DRR. Until the debentures have been reimbursed, this sum cannot be utilized. This method results in a reduction in the dividend available to shareholders. If dividends are reduced, the corporation retains enough funds to enable debenture holders to make a future payment. This minimizes the likelihood of the corporation failing to compensate for problems associated with profitability.
- An investment equal to the transfer made to the DRR is purchased every year. Investments can only be bought with securities authorized by the government. The investments cannot be sold except to fulfill the debenture holder’s liability. The consequence of this method is that the debenture liability for a part of the assets of the company can be repaid. Thus the likelihood of the company defaulting due to problems of profitability is reduced.
Applicability of Debenture Redemption Reserve
All businesses should have a DRR except as follows:
- Public Financial Institutions (PFIs) are enterprises with more than 51 percent of their paid-up share capital controlled by the central government. Examples are Infrastructure Development Finance Company Limited, Industrial Finance Corporation of India, Industrial Credit and Investment Corporation of India Limited, Life Insurance Corporation of India, and Industrial Development Bank of India.)
- AIFIs (All India Financial Institutions) are companies that operate under the Reserve Bank of India’s supervision) (RBI). The National Bank for Agriculture and Rural Development, the Export-Import Bank of India, the Small Industries Development Bank of India, and the National Housing Bank are all examples of such institutions.
Housing Finance Companies (HFCs) (If the company is registered with the National Housing Bank, the requirement to keep a DRR will be waived.)
- Non-banking Finance Companies (Non-Banking Financial Institutions) (NBFCs) (If the firm is registered under section 45-IA of the Reserve Bank of India Act, 1934, the requirement to keep a DRR is waived.) (In the case of a public debenture issue, the DRR should be created for unlisted NBFCs and HFCs.) Every bank on the schedule (scheduled banks are banks mentioned in the second schedule of the Reserve Bank of India Act, 1934).
- Listed Companies
The MCA implemented these changes in order to lower the cost of borrowing for businesses.
Earmarking of Funds
- The DRR should transfer part of the company’s profit. It should only employ profit available as a dividend for distribution. The debentures payable during the next financial year should be transferred.
- The transfer amount should be calculated as follows: 10% of the remaining debenture amounts (it was 25% till 15.08.2019) less the amount available in the DRR. The rate utilized for HFCs and NBFCs is 15% instead of 10%. The transfer was expected to take place before 30 April.
- The company’s financial managers should ensure that the DRR sum stays unchanged. This should be used only to reimburse debentures. The DRR should be established just for the non-convertible portion in cases of partially convertible debentures (partly convertible debentures carry the option to convert part of the debt into equity).
In the approved securities, the cash transferred to the DRR should also be invested. The securities approved are as follows:
- Deposits with scheduled banks
- Bills and commercial papers from the government
- Government’s long-term bonds
An investment is expected to take place before 30 April. The amount invested should be identical to the amount of the DRR transfer. The DRR’s ledger balance and the investment’s ledger balance should be identical.
The market value of the investments can be lower than that of the book value ( the amount shown in the ledger for the investment is known as Book value). In these circumstances, the book value should make an adequate adjustment. This adjustment is to reflect exactly the book value of the investment’s market value. The balance of the DRR will exceed the value of the investment once the adjustment is done. This makes it necessary to acquire extra investments. If it is demonstrated that a market value is not expected to increase, the book value of investments should be adjusted.
Utilization of Funds
In the case of repayment of debentures, the investments should be sold and the liabilities paid. The revenues from sales should only be utilized for the purpose of complying with the debenture owner’s obligation. The profit or loss of investments on the sale shall not be adjusted to the DRR. The balance of the DRR might be transferred to the General Reserve upon the settlement of the whole debt for the debentures.
As previously indicated, DRR assures that the corporation pays up its present profit for the repayment of long-term, non-convertible debentures. If a non-Convertible Debentures issuing company either fails or experiences a liquidity problem then its repayments normally are in default. This shows that Debenture Redemption Reserve is of paramount relevance here as it decreases the investment’s risk for debentures purchasers.