What is the Difference between Bonds and Debentures

Financing is the requirement of every organisation, whether it is a small organisation, a settled company, or even the government that requires huge funds for daily survival. Borrowing funds through loans is probably the most common way to get additional funds.

However, bank loans can be quite difficult for companies due to their high-interest rates. Sometimes, banks can also reject the loan approval due to several issues.

This is why companies often look for alternatives to avail additional funding. Among the different ways to raise money, equity and debt instruments are the prominent ones.

But, raising funds from equity instruments is usually quite risky, which is why some risk-averse companies prefer debt instruments to raise funds. When it is about the debt instrument, the two major sources of raising funds are the bonds and debentures issued by the government or companies. Both of them help to raise funds for the issuer.  

Usually, bonds are issued by the government, by large corporations, or agencies of the government. Similarly, debentures are issued by only public/private companies to raise funds from the market. Sometimes, both the words are used interchangeably, but in reality, both of them are quite different from one another.

Let's take a detailed look at both the investment tools and understand how they are different from each other.

Difference Between Bonds and Debentures

Bonds and debentures seem to be similar, but many investors are not aware of how different they are from each other. Let's understand the prime difference between bonds and debentures based on various factors:

Key Difference Based on the factors

Following are some key differences between bonds and debentures based on the various factors:

What is a Bond?

Bonds are a kind of debt instrument that is issued by a company or government to raise capital. It is a contract between two parties, wherein, the issuer issues the bond with a fixed maturity date, and in most cases, a bondholder is benefitted from a fixed rate of interest periodically.

Let's take a look at some key features of the bond:

• Bonds offer long-term finance; the maturity period of bonds can be 5 years. However, government bonds can be issued for a longer period, even for 10 years or more.
• The bonds represent the borrowed capital and bondholders become the creditors of the company.
• The bondholders get a fixed interest rate of interest as income. The interest may be paid annually or during the maturity period.
• The bonds are redeemed after a certain period, as mentioned in the bond certificate.
• The bonds issued by the government corporations are guaranteed by the state/central government. Therefore, there is less risk of default in repayments.
• Certain bonds get tax benefits. For example, there is an exemption from the capital gains tax, if the taxable amount is a taxable amount that is invested in certain government bonds.

What is a Debenture?

Debentures are unsecured debt instruments that are not backed up by security. Private companies use debentures to raise money for upcoming projects/to expand their business or to raise short-term capital. The government does not issue debentures.

A debenture can offer a fixed interest rate or a floating interest rate. Usually, a fixed interest is taken out against a tangible asset such as property. It allows the lender to take ownership of the borrower's assets and sell them off in the case of a payment default. With a fixed interest rate, the borrower would not be able to sell the asset without the lender's permission.

Here are some of the key features of debentures:

• Debenture holders do not have any voting rights. But debenture holders have the right to sue the company for any unpaid dues.
• Debenture holders are also entitled to the redemption of their capital as per the agreed terms.
• Debenture holders receive periodical payment of interest at an agreed rate.
• Debenture holders can apply for the winding up of the company to safeguard their interests.
• Debenture holders can enforce the security by sale in case of default.

Who Should Invest in Bonds and Debentures?

Investment in bonds might be an ideal investment for risk-averse investors as bonds are offered by the company and government agencies. There is no specific time to invest in bonds. For a secure investment, investors should invest in high rated bonds. Those who wish to take a little more risk can opt for the lower-rated debt instrument that can offer higher returns.

Only private/public companies offer the debentures, which eventually makes it slightly riskier as there is no backup to secure the investor's investment. But investors who wish to earn a higher return and are willing to take a risk on their investment can choose to invest in debentures. 

The Bottom Line

A bond and a debenture are both structures of borrowed capital; however, the distinction comes from within the nature of each instrument. A bond is backed by collateral, whereas a debenture isn't. 

However, the scope of earning is usually high with debentures. If you've got the flexibility to measure the trustworthiness of the issuer of the debentures, you'll undoubtedly obtain debentures for a stronger profit. However, if you are new to the sector of an investment, then bonds are a stronger selection for you. 

Bonds are comparatively additional secured as they are issued by government agencies; hence the returns are granted here. However, if your risk tolerance is high, and you wish to earn a higher profit in less time, debentures can be a better selection for you.

In the end, the choice will depend on your risk tolerance and financial goals.

Invest wisely!