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
Bonds vs 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:
| Parameter | Bonds | Debentures |
| Meaning | Bonds are debt instruments issued by private corporations and governments with the backing of physical assets or collateral. | Debentures are debt instruments issued by private corporations to raise capital without the backing of physical assets or collateral. |
| Owner | Owners are known as bondholders. | Owners are known as debenture holders. |
| Tenure | Bonds are long-term investment instruments with a longer tenure than debentures. | Debentures usually have a shorter tenure than bonds. |
| Collateral | Bonds are secured by collateral from the issuing entity. | Debentures are usually unsecured, backed by the creditworthiness of the issuer. |
| Risks involved | Bonds are relatively safe investments since they are backed by collateral. | Debentures are riskier since they usually lack the backing of physical assets. |
| Interest rate | Bonds generally offer a lower rate of interest due to collateral support and the possibility of stable future repayment. | Debentures offer a higher interest rate than bonds because of the higher risk quotient. |
| Interest payment | Payments for bonds happen on an accrual basis. The interest amount is paid on a monthly, semi-annual, or annual basis and is not hinged on the company’s performance. | Payments are made on a periodic basis, depending on the company’s performance. |
| Liquidity priority | Bondholders receive first preference in terms of capital and interest payment when a company is on the verge of liquidation. | Debenture holders are compensated after bondholders when a company liquidates its assets. |
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.
