Updated July 14, 2023
What are Bonds and Debentures?
Bonds and debentures are two of the most frequently used debt investment options for investors. While companies issue debentures as convertible or non-convertible debt securities, bonds are issued by government agencies or companies as debt certificates to raise funds.
In fact, in the US, a debenture is considered the type of bond with no collateral security, while in most countries, both terms are used interchangeably.
Explanation
Whether a small enterprise, a large multinational company, or a government agency, every entity needs to raise funds to run its operational activities, and that is when some of these entities decide to borrow from the public. While many different ways of borrowing money, bonds and debentures are the most prominent among the available options.
Characteristics of Bonds and Debentures
The bonds exhibit the following characteristics:
- The bonds have a face value or par value that is paid to the bondholder at the time of maturity. It is usually $1,000 for corporate bonds but can be greater for government bonds.
- Most bonds pay coupons every 6 months but can also make the payment monthly, quarterly, or annually.
- The maturity period can be as pintsize as 1 day, up to 30 years. The thumb rule is that the coupon rate is directly proportional to the maturity period –the longer the maturity period higher the coupon rate.
The debentures exhibit the following characteristics:
- Usually, the debentures are part of a series issued over a particular period of time.
- The holders of debentures are creditors for a company, and thus they don’t possess any voting rights.
- The interest rate paid on debentures is fixed in nature.
- The debentures are long-term funding sources, and the maturity period usually falls from 10 to 20 years.
How to Invest in Bonds and Debentures?
One should have a trading and Demat account to invest in bonds and debentures. The investors can either trade themselves or ask the brokers to trade on their behalf. However, the investment decision should be based on the repayment period and the securities’ expected rate of return.
Types of Bonds and Debentures
The bonds can broadly categorize into the following types:
- Actively managed bonds: The fund managers of these types of bonds actively trade the funds to achieve the investment goal of higher returns than the market.
- Passively managed bonds: The fund managers of these types of bonds benchmark the fund allocation to a particular index such that the fund performance mimics that of the index, and thus these bonds are also known as index funds.
- Open-end bonds: In these types of bonds, the fund managers can make new offers in the market to either meet additional fund requirements or redeem the existing ones. The existing investors can re-invest in the new fund offerings after redeeming their investments.
- Closed-end bonds: The number of tradable shares is limited in these types of bonds. These bonds can either actively manage or indexed funds.
- Exchange-traded funds: These funds are bouquets of various bonds with unlimited shares. These bonds trade on the exchange through brokers and thus the name.
The debentures can broadly categorize into the following types:
- Convertible debentures: These types of debentures come with the option of conversion into equity shares or securities. Some of the debentures are partly convertible, while some are fully convertible.
- Non-convertible debentures: These debentures can’t convert into equity shares or securities. Typically, non-convertible debentures offer a higher return as compared to convertible debentures.
- Secured debentures: Collateral securities back these types of debentures in the form of the company’s assets.
- Unsecured debentures: Any kind of collateral securities does not back these debentures.
Difference Between Bonds and Debentures
Let us look at some of the major differences between bonds and debentures.
|
Bonds |
Debentures |
| A claim usually secures them against company assets. | Not all debentures are secured by collaterals. |
| Corporations, government agencies, or financial institutions issue them. | Private companies mostly issue them. |
| They are relatively less risky. | These are at relatively higher risk. |
| In the case of company liquidation, bonds are placed higher on the priority list. | Regarding company liquidation, debentures are placed below bonds and above equity & preference shares on the priority list. |
| They offer a relatively lower rate of interest. | They provide higher interest rates. |
Advantages
Some of the major advantages of bonds and debentures are as follows:
- Both bonds and debentures consider suitable for conservative investors.
- The prices of bonds and debentures are more stable as compared to equity shares.
- They are significantly cheaper sources of funding as compared to equity funding.
Disadvantages
Some of the major disadvantages of bonds and debentures are as follows:
- The interest paid on bonds and debentures is cumulative in nature, which means that it has to be paid irrespective of whether the issuing entity earns a profit or incurs a loss. This can result in a significant financial burden for the companies during economic downturns.
- These investors neither have any company management representation nor voting rights. Thus, they have no control over company affairs.
Conclusion
So, it can be seen that various companies and government agencies raise funds by issuing bonds and debentures. Both of these are debt funds, and most conservative investors participate. Additionally, some debentures come with the option of conversion to equity shares or some other securities. An investor needs to consider the repayment period and the expected return rate before investing.
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