Debentures vs bonds - 8 Key differences between bonds and debentures as of 2023

Bonds and debentures are very popular debt instruments. However, many people often confuse the two. Here are eight key areas in which they differ.

Over the past two years, debt markets have experienced considerable strain in India and across the globe due to central banks' efforts to combat soaring inflation by raising interest rates. As we approach the end of the rate hike cycle and witness a surge in yields, the debt market emerges as an alluring investment opportunity. Two debt securities - bonds and debentures are among popular investment instruments. Before you invest in either, it is important to understand their differences and functions. 

Key highlights

• Bonds are secured by collateral, while debentures may be unsecured, relying on the issuer's creditworthiness
• Bonds have longer tenures, while debentures have shorter tenures based on the issuer's needs
• Bondholders have priority in repayment during liquidation, while debenture holders are at a lower priority

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.

Also Read: A Beginner's Guide To Investing In Non-Convertible Debentures 

Bonds and debentures are very distinct from one another. Let’s move to understand the points of difference between bond and debenture to give you a clear idea.

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Some key differences between bonds and debentures

1. Collateral requirement: The need for collateral is one of the primary features that distinguishes bonds and debentures. 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: Another difference between bond and debenture is that 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 and debentures are issued by different entities. 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: The varying level of risk is a primary bond and debenture difference that you must consider before investing your money in either of the two. 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.

Related: What do market losses mean for mutual funds? 

5. Rate of interest: Another major distinction between bonds and debentures is their 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: One more bond and debenture difference is that in the event of liquidation of an organisation, bondholders are given priority in repayment as compared to debenture holders. This can be a significant advantage for bondholders and a major consideration for investors to take note of before investing money in either instrument.

Conclusion

The bond vs debenture debate is a common one. 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.

It is important to clearly understand the difference between bond and debenture to ensure you choose the financial instrument based on what you hope to gain from your investments.

Debt funds are appropriate for short-term investment and reduced risk, whilst equity funds are suitable for long-term aims. Achieving a balance between these two might be difficult. The time horizon, risk necessary to attain your goal, risk capacity, and risk tolerance are important parameters to consider when deciding between different instruments funds. Diversify your risk by investing in both debt and equity funds. This will assist you in attaining your many goals, both short and long term.

Check out this Premium Article to learn how to choose the right instrument.