When companies require additional funding, they often borrow funds through loans to finance their needs. Bonds and debentures are the most common types of borrowing options used to raise capital. Both are debt instruments issued by governments and companies, where the investor is promised a fixed return of the borrowed sum and interest payment on the principal amount.
Despite this overarching similarity, differences between bonds and debentures are many. As an investor, it is crucial to understand bond and debenture differences to make informed decisions.
In this article, we cover each, highlighting the key differences between bonds and debentures in detail.
What is bond?
A bond is a common debt instrument issued by large corporations, governments, and government agencies to raise capital for financing projects. Bonds act as promissory notes between the bondholder and the issuer. The investor (bondholder) lends the issuer a sum of money in return for a promise of repayment on or before a certain maturity date. Investors receive periodic interest payments on their invested sums.
Bonds are considered relatively safe investment avenues since they are backed by tangible assets of the issuer. Highly-rated corporate or government bonds bear little default risk but offer lower returns than debentures. Some common types of bonds available to investors include:
- Fixed-rate bonds
- Floating rate bonds
- Callable rate bonds
- Convertible bonds
- Zero coupon bonds
- Puttable bonds
What are debentures?
A debenture is a type of unsecured debt instrument issued by private companies to raise capital for specific purposes like financing the cost of an upcoming project or funding expansion plans. As unsecured debt instruments, debentures are not backed by the physical assets of the issuer, making them inherently riskier. Instead, they are backed by the creditworthiness and credit ratings of the issuer. Interest is paid based on the coupon rate of a debenture, which may be fixed or floating. Common types of debentures include:
- Unsecured debentures
- Non-convertible debentures
- Convertible debentures
- Secured debentures
- Redeemable debentures
- Unredeemable debentures
Difference between bonds and debentures
From the above discussion, it is clear that there are several differences between bonds and debentures. To help you understand these disparities more clearly, we have summed up all the bond and debenture differences below:
Aspect |
Bonds |
Debentures |
Definition |
Bonds are debt instruments issued by financial institutions, large corporations, and government agencies. They are secured by collaterals or physical assets. |
Debentures are debt instruments issued by private companies without any backing of collaterals or physical assets. |
Owner |
The individual holding a bond is referred to as a bondholder. |
The individual holding a debenture is known as a debenture holder. |
Tenure |
Bonds typically have a longer tenure. |
Debentures usually come with a comparatively shorter tenure. |
Risk |
Bonds carry lower risk as they are secured by collateral. |
Debentures have a higher risk since they are not secured by any collateral. |
Collateral |
Bonds are backed by the issuing entity’s physical assets or collaterals, ensuring security for investors. |
Debentures are unsecured, relying solely on the creditworthiness and reputation of the issuer. |
Who should invest in bonds and debentures?
Bonds and debentures are low-risk financial instruments favoured by risk-averse investors. These investments are better-suited for investors seeking stability and steady income flows instead of aggressive growth. From the bonds and debentures differences highlighted above, it is clear that bonds appeal to investors like retirees who value capital preservation and fixed income flow against a relatively lower rate of return.
Bonds may also be a safe option for beginners just starting on their investment journeys. Alternatively, debentures may be better suited for investors seeking higher returns and willing to shoulder relatively higher risks. They are better options for investors with a short-term investment horizon.
Conclusion
Understanding the bond-debenture differences is crucial for investors looking to diversify their portfolios with fixed-income assets. While both are debt instruments, bonds are backed by collateral, while debentures lack asset backing. However, the added safety of a bond comes at the cost of better returns. In other words, with a higher risk quotient, debentures offer better return potentials than bonds. In a nutshell, if you are a low-risk investor seeking a stable income stream, opt for bonds. If you can evaluate the creditworthiness of the issuer and have a higher risk tolerance, invest in debentures.
