What is the Difference Between Bonds and Debentures?

A bond is a type of security under which the debtor or issuer owes the holder debt. The debtor is obliged to offer cash flow to the creditor at the time of maturity along with bond and interest. A debenture is a medium to long-term debt instrument that is opted for by large companies for borrowing money at a fixed interest rate.

In this article, we will be discussing the differences between bonds and debentures. Let us get started.

Table of Contents

• Difference between bonds and debentures
• What are bonds?
• What are debentures?
• When and Which one to Choose: Bonds or Debentures?

Differences Between Bonds and Debentures

The following table gives a glance at the differences between debentures and bonds.

What are bonds?

A bond is a fixed-income instrument that represents a loan given out by an investor to a borrower. These are the fixed-income securities that are one of the main classes of assets. The details of a bond include the end date and variable or fixed interest payments that are made by the borrower.

These debt securities are used by the government and companies for financing operations and projects. Bonds allow individual investors to take on the role of lender. Public debt markets allow investors to lend a portion of their capital to those who require it. The market enables lenders to sell their bonds or buy bonds after the issuing organization has raised capital.

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Benefits of Bonds

The following are the benefits of bonds:

• Bonds provide a predictable income stream that pays twice the interest amount in a year.
• If bonds are held till maturity, the bondholder gets back the entire principal amount and helps you preserve capital while investing. It can help offer exposure to volatile stock holdings.
• For companies, bonds help in getting money so that it provides operating cash flow. It also helps them with funding capital investments for different projects.
• It helps in earning predictable returns while preserving capital. Prior to maturity, it provides a steady flow of income through interest payments.
• When held till maturity, it allows investors to receive both face value and interest. In case it is sold before maturity, its value may change and might be more or less than face value.

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Types of Bonds

The following are the different types of bonds:

• Corporate Bonds: These are the bonds that are issued by a corporation for raising finance to fund ongoing operation, mergers and acquisitions and to expand the business.
• Municipal Bonds: These are one of the types of debt securities that is issued by the government for funding projects. Such bonds are similar to loans since bondholders become creditors in this case. These are exempt from most of the taxes due to which these are preferred by high net worth individuals.
• Government Bonds: These debt securities are issued by the government to repay its spending and obligations. These are safer investments since they are backed by the issuing government. Some of the government bonds may pay periodic interest payments while some other are sold at a discounted rate.
• Agency Bonds: Also known as agency security, these are issued by government-sponsored enterprises or by federal agencies. These are issues through broker-dealers.

What is a debenture?

A debenture is a bond type and other debt instruments that have no collateral backing. These financial instruments rely on the creditworthiness and reputation of the issuer for support. Both government entities and corporations issue debentures to raise funds. Debentures issued by government entities have a term that is greater than 10 years.

It may pay periodic interest payments that are known as coupon payments. These are documented in an indenture similar to other types of bonds. The debentures issued by corporations are also long-term in nature, but these are unsecured. These have the backing of financial viability and creditworthiness of underlying companies.

Benefits of Debentures

The following are the benefits of debentures:

• Since debentures are treated as a liability to any business, debenture holders are paid off first.
• These are cost-effective in comparison to other forms of lending.
• Debentures provide a fixed rate of interest for lending, which is paid before any dividends are issued to shareholders.
• The ownership of the company remains intact since debenture holders do not have the voting rights or participation in company meetings.

Types of Debentures

Following are the different types of debentures:

• Registered debentures: These comprise of all details comprising of names, addresses, and particulars of holding of debentures. These are filed in a register that is kept by the enterprise.
• Bearer debentures: These can be transferred via delivery, due to which the company does not maintain the record of debenture holders in this case. Whoever produces the interest coupon attached to such debentures is paid the interest.
• Redeemable debentures: These provide the exact terms and the date by which the bond issuer must repay the debt in full. These fixed-income instruments are on which investors receive periodic payments as interest.
• Irredeemable debentures: These debentures are not redeemed during the lifetime of a company. Debenture holders, in this case, are paid off when the company winds up. However, debenture holders enjoy periodic interest payments throughout the company’s life.
• Convertible debentures: It is possible to convert these types of debentures into equity shares of issuing corporations after a certain period. These are the hybrid financial products that provide the benefit of debt and equity.
• Nonconvertible debentures: These are traditional debentures that cannot be converted into equity of issuing corporation. Due to the lack of convertibility, investors are provided with a higher rate of interest as compared to convertible debentures.

When and Which one to Choose: Bonds or Debentures?

Choosing between bonds and debentures depends on various factors including investment goals, risk tolerance, and market conditions. Here's a comparison to help you decide when to prefer each:

Bonds

1. Government or Corporate Backing: Bonds are typically issued by governments or corporations. Government bonds are generally considered safer due to government backing.
2. Security: Bonds are often secured, meaning they are backed by specific assets of the issuer. If the issuer defaults, bondholders may have a claim on those assets.
3. Risk Level: Generally, bonds carry a lower risk compared to debentures, especially government bonds.
4. Interest Rates: Bonds usually offer lower interest rates due to their lower risk profile.
5. Prefer When:

• Seeking a safer, more secure investment.
• Looking for a steady income stream with lower risk.
• Investing in a volatile or uncertain market where security is a priority.
• Preferring an investment with potential tax benefits (like municipal bonds in the US).

Debentures

1. Typically Corporate Issued: Debentures are usually issued by companies and are not secured by physical assets.
2. Unsecured Nature: They are unsecured, relying on the creditworthiness and reputation of the issuer.
3. Risk Level: Higher risk compared to bonds, but offer higher interest rates to compensate for this increased risk.
4. Return Potential: Generally offer higher returns due to the higher risk involved.
5. Prefer When:

• When you are ready to take on more risk for potentially higher returns.
• Confident in the financial stability and creditworthiness of the issuing company.
• Looking to diversify an investment portfolio with different types of fixed-income securities.
• In a stable or bullish market where corporate health is generally strong.