Any organisation needs funds for basic requirements such as, for setting up or expanding a business. Borrowing is the most common way to avail of the funds required. There are different ways companies can borrow, among which bonds and debentures are the most prominent ones. Both debenture and bonds are debt instruments, and in many countries, they can use them interchangeably. However, they both are different investment tools. In this article, let us understand the difference between bonds and debentures.
What is Debenture?
Debentures are unsecured debt instruments that any company assets or collateral does not back them. The investors have to rely on the credit ratings of the issuing company as security. Most private companies use debentures as a tool to raise funds for many reasons. For instance, a company issues debentures when expanding its business.
What are Bonds?
Bonds are the most common debt instrument. Usually private companies, governments and other financial institutions issue them. They are loans that are secured by collateral. The organisation that issues bonds becomes the borrower who promises the repayment of principal and interest at specified maturity date. Also, they fix the interest rate for the duration of the bond’s term.
Debentures vs Bonds
The following table shows differences between debenture and bonds.
|Collateral||Debentures may or may not be backed by collateral. Thus, investors have to purchase based on the credit rating of these companies.||Generally, bonds are secured by collateral.|
|Tenure||Companies issue debentures for a short or long term period on the basis of their fund requirement.||The tenure of Bonds is generally longer than debentures.|
|Issued by||Mostly private companies issue debentures.||Mostly large corporations, government agencies, financial institutions, etc. issue bonds|
|Interest Rate||Debentures offer higher interest rates as they are unsecured. Also, the investor relies only on creditworthiness and reputation of the issuer.||Bonds offer lower interest rates as there is repayment stability in future and also collateral backs them.|
|Payments||The payment of interest on debentures is periodical as per the prospectus. However, this depends on the performance of the issuing company.||The interest payment on bonds is on an accrual basis, i.e. monthly, half-yearly or annually. The performance of the business does not affect these payments.|
|Risk||Debentures are riskier as any collateral does not back them. It is only the reputation of the issuing company and the ratings by credit rating agencies.||Bonds are safer than debentures as some form of collateral backs them. Also, the issuing party is reviewed periodically and rated by the credit agencies.|
|Convertibility||Issuing company can convert only convertible and also partially convertible debentures into equity shares on the expiry as specified in the clause.||Bonds cannot be converted into equity shares of the company|
|Liquidation||During liquidation, the debenture holders are paid after the bondholders.||During company liquidation, Bondholders are given priority over the debenture holders.|
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Who Should Invest in Debentures?
Investment in debentures is suitable for investors with high-risk tolerance levels. Even though the return from debentures is predictable, there is no guarantee for the same. Debentures are riskier than bonds because any collateral does not back debentures. Thus, investors have to select the company based on its creditworthiness and reputation for investment. Also, debentures are subject to interest rate fluctuations.
One advantage of debentures is in the case of convertible debentures. Here the investors can convert them into equity shares of the company. Additionally, investment in debentures offers higher returns to investors than bonds. However, they carry certain risk with it. Thus, debentures can act as a short-term investment option for investors, helping them diversify their investment portfolios.
Who Should Invest in Bonds?
Investment in bonds is suitable for investors who have low-risk tolerance levels. Bonds are safer investments than debentures. They carry less risk as there is a principal and fixed interest payment guarantee after a specified duration. Also, since these securities, no collateral backes them, it ensures investors will receive their payment on maturity. Thus, bonds can act as a long term investment option for investors who do not have experience in the stock market.
Typically, bonds carry less risk. However, investors should consider the inflation risk, which may cause the investments to lose their value over time. Also, investing in bonds can help investors generate a steady source of income. Furthermore, it helps them diversify their portfolio through investment in these bonds.