- Date : 10/02/2020
- Read: 4 mins
Bonds and debentures are very popular debt instruments. However, many people often confuse the two. Here are eight key areas in which they differ.
An organisation may need financing at any time. In fact, funds are a basic requirement for setting up or expanding a business. Most companies prefer debt instruments like bonds and debentures to gather these funds. Although both terms are used interchangeably in many countries, the fact is they are distinctly different.
Defining bonds and debentures
Bonds are probably the most common type of debt instrument used by private corporations, government agencies, and other financial institutions. Bonds are essentially loans that are secured by a physical asset. The holder of the bond is considered to be the lender while the issuer of the bond acts as the borrower. The bondholder, or lender, loans money to the borrower with the promise of repayment at the specified maturity date. Generally, the lender also receives a fixed rate of interest during the duration of the bond’s term.
Debentures, on the other hand, are unsecured debt instruments that are not backed by any collateral. Rather, the good credit ratings of a company issuing a debenture act as the underlying security. Corporations use debentures as a tool to raise funds for various reasons. For instance, a debenture might be issued when a company is undergoing a cash crunch. On the other end of the spectrum, a debenture can also be issued when a company wants to expand its business with a new project.
Some key differences
1. Collateral requirement: Bonds are secured by some kind of collateral. Debentures, on the other hand, might be secured or unsecured. In most cases, large and reputable public companies issue debentures without any collateral as people are willing to purchase the debenture based solely on the trust that they have in such companies.
2. Tenure: Bonds can be considered as long-term investments and accordingly, the tenure of bonds is generally long. As for debentures, the tenure is mostly short-term in nature, based on the requirement of the issuing company.
3. Issuing body: Bonds are generally issued by financial institutions, government agencies, large corporations, and the like. Debentures are issued by private companies in almost all cases.
4. Level of risk: Bonds are regarded as safe havens for lenders because they are backed by some form of collateral. Another reason is that corporations that offer bonds are periodically reviewed and rated by credit rating agencies. Debentures carry a higher risk as they are generally not backed by any kind of collateral. Instead, they are backed solely by the faith and credit of the issuing party.
5. Rate of interest: Bonds generally offer lower rates of interest since the stability of repayment in the future is high. Moreover, all bonds are backed by collateral too. In comparison, debentures offer a higher rate of interest as they are mostly unsecured by collateral and are backed only by the reputation of the issuer.
6. Payment structure: The payment of interest on bonds is on an accrual basis. Lenders are generally paid monthly, semi-annually, or annually. The business performance of the issuing party has no effect on these payments. When it comes to debentures, the interest payment is done on a periodical basis, which can often depend on the performance of the issuing company.
7. Convertibility into shares: Bonds cannot be converted into equity shares while certain debentures do offer this facility. Convertible debentures allow holders to convert their debentures into shares if they believe that the company’s stock will rise in the future. It has to be noted, however, that convertible debentures pay lower interest rates when compared to other fixed-rate investments.
8. Priority in case of liquidation: In the event of liquidation of an organisation, bondholders are given priority in repayment as compared to debenture holders.
Ultimately, while they may be similar in nature, bonds and debentures are two discrete debt instruments that differ in many ways. While people often get confused between the two and use them interchangeably, it is important to know the differences. After all, the first step towards avoiding investment risks is to always have the pertinent and correct information at your disposal.