When companies or governments need to raise funds, they often turn to the bond market. Although bonds and debentures often get used interchangeably, they have some key differences. We’ll explore the distinctions between bonds and debentures, including their structures, characteristics, and benefits.
- Debentures are debt instruments typically used to raise capital for specific purposes, such as business expansion or a new product launch. They are not backed by physical assets. Instead, they rely on confidence and trust in the issuing corporations or government agencies.
- Bonds are generally considered safe investments due to the low risk of default. However, they may not have high-interest rates compared to other investment options, such as stocks or real estate.
Debentures are a type of bond that companies, financial institutions, and governments issue to raise capital. But, unlike traditional bonds, they rely solely on the full faith and credit of the issuer, making them riskier for investors. In other words, they are not supported by any tangible assets or security. That means if the issuer can’t repay the loan, their assets may get sold to repay the lenders.
Compared to other bonds, debentures typically have a more specific purpose in raising capital, as they are often issued to fund an upcoming project or planned expansion. For example, a company may issue a bond to raise money for a new product launch or service offering. Corporations typically take out these debt securities as a form of long-term financing.
Debentures provide a return on investment (ROI) to investors in the form of a coupon rate that may be either floating or fixed, and they mention a date by which the debt must get repaid. When the time comes for the issuer to make the interest payment, they will typically pay the interest first, followed by shareholder dividends.
The issuer typically has two choices to repay the principal. They can either make a single payment in full or make installment payments. With the installment plan, also known as debenture redemption reserve, the company will pay you a set amount annually until the debenture reaches maturity.
Debentures are sometimes referred to as revenue bonds. Some debentures are convertible, meaning their value can be changed into that of the issuing company’s assets or stock, while others are non-convertible. Generally, investors prefer convertibles and are willing to accept a slightly smaller return to get them. Like with any other bond, you can buy debentures via a broker.
While all debentures are bonds, not all bonds are debentures. Bonds are a debt instrument that corporations and governments use to raise money. Investors will loan a predetermined sum of money to the bond issuer in exchange for repayment with interest over the duration of the bond’s terms.
Unlike debentures, bonds are secured by collateral or tangible assets. However, the interest rates are typically lower because they are lower-risk investments. Assets with less risk tend to provide smaller returns.
Compared to other assets, bonds are considered a relatively safe investment. Bonds issued by highly rated corporate or government agencies have a low risk of default. But, each bond carries an independent credit rating, so you need to check the bonds beforehand. If a bond has a poor rating, the issuer is likely in a bad financial state and may not have the means to pay you back.
In most cases, bonds are a way to hedge against riskier investments. Financial advisers generally recommend people invest a portion of their wealth in bonds to diversify their portfolios and preserve their wealth as they get closer to retirement.
A Head-to-Head Comparison of Bonds and Debentures
Corporations with a strong reputation or creditworthiness usually issue debentures since they carry more risk than other types of bonds. Investing in a failing company can be highly risky, especially when the investment is not secured.
To determine a corporation’s creditworthiness, credit-rating agencies assign letter grades, with “AAA” being the highest rating and “C” and “D” being the lowest. You should invest only in debentures issued by companies that receive a BB rating or higher if you want to be on the safer side. Debentures with a rating lower than BB are classified as “junk bonds,” meaning you may not get your money back.
The time to maturity for bonds and debentures can vary depending on the terms of the issuance. Bonds are typically issued with longer maturities, ranging from 10 to 30 years or even longer, and the repayment of the principal and interest is spread out over the duration of the bond. This longer time horizon allows the issuer to fund long-term projects and investments.
On the other hand, debentures usually have shorter maturities, ranging from 1 to 10 years. They are often issued to fund short-term projects or to provide working capital. Since they have a shorter time horizon, debentures usually have higher interest rates to compensate investors for the shorter time period.
Interest rates for bonds and debentures may vary depending on the issuer and the market conditions. But in general, debentures offer higher interest rates than bonds because they carry higher risks and are less stable in terms of repayment.
Both bonds and debentures carry either a fixed rate or a floating interest rate. A fixed interest rate refers to an interest rate that remains constant throughout the tenure of the instrument. For example, if a bond has a fixed interest rate of 5%, the issuer will pay the investor 5% interest every year until the specified maturity date regardless of changes in the market.
On the other hand, a floating interest rate, also known as a variable interest rate, is a rate that changes periodically throughout the tenure of the instrument based on changes in market interest rates. The interest rate is usually linked to a benchmark rate, such as the prime rate or LIBOR. As the benchmark changes, so does the floating rate.
Additionally, debentures may get structured as convertible debentures, which means that the debenture holder can convert the debenture into shares of the issuing company at a predetermined conversion price. This structure allows investors the chance to own equity shares and benefit from potential share price appreciation while still receiving a fixed income stream in the form of interest payments.
The Bottom Line
When deciding between bonds and debentures, carefully consider the risks and benefits of each financial instrument. Debentures usually offer a higher return but come with a higher risk of default, while bonds offer greater security for lower returns.
The issuer’s creditworthiness is a crucial factor to consider, and you should only invest in companies with strong financial performance and credit ratings. Ultimately, choosing between debentures and bonds depends on your risk tolerance and investment objectives.