Every business needs money to maintain its operations. Large corporations raise capital by issuing publicly traded shares. However, not all businesses that are ready to go public can afford it—particularly newer businesses. One typical method of getting money is by borrowing. Businesses borrow money by issuing bonds and debentures. In this article, we look at the differences between bonds and debentures.
Bonds and Debentures
Bonds are loans from investors to issuers like governments and businesses. The investor receives interest on the investment while the borrower uses the funds to support its operations.
A debenture is also a debt instrument. It is a form of long-term business loan issued by a company to meet its financial needs. Investors are rewarded for lending money to the issuer by receiving interest income in return. They typically have a long tenure, usually extending ten years, and are an unsecured form of bond.
Differences between Bonds and Debentures
| # | Bonds | Debentures |
|---|---|---|
| 1 | Bonds are debt financial securities backed by collateral or tangible assets and are issued by large corporations, financial institutions, and governmental organizations. | Debentures are issued by private firms and are not backed by any collateral or tangible asset. |
| 2 | Collateral or physical assets of the issuing corporation are used to secure bonds. | Debentures are not backed by the issuing company’s physical assets or collateral. Instead, lenders only consider the issuing company’s reputation when making this investment. |
| 3 | Bonds are long-term investments, and their tenure is generally longer than debentures. | Debentures often have a shorter tenor than bonds and are more suitable for short- to medium-term investments. |
| 4 | Because the issuing company’s assets provide security, bonds are less risky than debentures. | Debentures lack the backup of physical assets of the issuing corporation, whereas bonds do, making debentures riskier than bonds. |
| 5 | Bond interest is paid out on an accumulation. The issuing corporation pays this sum on a bi-annual or annual basis, and it is not based on how well the business performs. Bond is a fixed-income instrument. | Bond interest is paid periodically and is influenced by the company’s success. |
| 6 | Big corporations, financial institutions, and governmental organizations issue these bonds to meet their long-term capital needs. | Private companies typically issue debentures for their immediate capital needs. |
| 7 | Because they are more reliable in terms of repayment and are secured by the issuing company’s assets, bonds have a fixed or floating interest rate that is often lower than debentures. | Because they are less reliable in terms of repayment and are not backed by collateral, debentures have a fixed or floating interest rate that is often higher than bonds. |
| 8 | If a corporation is about to go out of business, bondholders are given preference over holders of debentures when it comes to repayment of capital and interest. | Debenture holders are given second priority over bondholders for repayment of capital and interest amount if the company is about to go out of business. |
Types of Debentures
- Registered vs. Bearer
- Redeemable vs. Irredeemable
- Convertible vs. Inconvertible
- Secured and unsecured
- Perpetual
- Fixed charge and floating charge
Types of Bonds
- Traditional Bonds
- Corporate bonds
- Municipal bonds
- Callable Bonds
- Mortgage Bonds
- Fixed Rate Bond
- Serial Bond
- Callable Bond
- Climate Bond
- Inflation Linked Bond
- Extendable Bond
- Puttable Bond
- Floating Bond
Advantages and Disadvantages of Debentures
Advantages of Debentures
- Debentures can help a business thrive by promoting long-term funding. In comparison to other financing methods, it is also economical.
- Debentures often offer a fixed interest rate to the lender, which must be paid before issuing any dividends to shareholders.
- Existing shareholders’ ability to influence the company’s direction and profit-sharing percentage remain unchanged.
- Directors are given important financial security and assurance concerning their finances.
Disadvantages of Debentures
- Their commitment to pay interest on the debt is rigid and unalterable. This can hinder business expansion and, in rare situations, even cause insolvency during tough financial times.
- The lender forfeits their right to vote and receive a share of company earnings by holding a debenture.
- The limitations imposed by securing the debenture with a certain asset or class restrict the management’s ability to manage or use the assets as they see fit.
- Debentures permanently reduce a company’s ability to make money. Therefore, when the company’s earnings fluctuate, there is a bigger risk.
What are convertible debentures?
Convertible debentures are bonds that have an expiration date and can thereafter be changed into the equity of the issuing company. The advantages of both debt and equity are combined in convertible debentures, a hybrid financial product. Investors who wish to convert their convertible debt into equity are drawn to convertible debentures if they anticipate long-term gains in the value of the company’s stock.
What are convertible bonds?
Convertible bonds are interest-bearing fixed-income corporate debt assets that can be converted into an unspecified number of common stock or equity shares. Companies profit because they can borrow money at interest rates lower than those of conventional bond offerings. However, not all businesses provide convertible bonds.
Where are debentures traded?
Debentures are issued through brokers and syndicates.
Is it safe to invest in debentures?
Investors have a high level of risk because they are not secured. Also, debenture holders will be compensated last after other creditors in the event of bankruptcy of the corporation.
Who are debenture holders?
A debenture holder is an individual or organization that has made a debenture-based loan to another individual or organization.
Can debentures be issued at a discount?
Unlike shares, debentures can be issued at a discount and are referred to as “Debentures issued at a Discount.” Giving debentures at a discount raises the company’s capital.
When is debenture interest payable?
Interest on debenture is calculated at a fixed rate according to the terms of the issue, on its nominal (face) value, payable every quarter, every half-year, or every year. The interest rate is a prefix value for the debenture, such as 9% Debentures. It is consequently payable even if the company faces a loss. Whether there are profits or losses, interest on debentures must be paid.
What is the difference between debenture holders and shareholders?
Shareholders take an active part in the company’s decision-making process. Debenture holders are not permitted to take part in decision-making. A shareholder purchases a company’s shares. Debenture holders purchase loan securities.
Bottom Line
Bonds and debentures are lower-risk alternatives to shares and differ from one another in a variety of ways. However, both are necessary when finding funding to support a corporation’s immediate and long-term needs. They are a financing choice for businesses with strong finances that don’t want to issue shares and erode their equity.
