Difference Between Bond and Debenture

Difference Between Bond and Debenture: A Detailed Analysis for Investors

For any investor or an issuer, it is crucial to understand the difference between bonds and debentures. Although both are used for fundraising, they are accompanied by specific traits, advantages, and disadvantages that form a crucial part of finance. This extensive analysis will elaborate on the distinctions between bond and debenture to ensure the decision-maker understands them.

Bonds

Bonds are fixed-income securities often used by the government, banks or other big companies for long-term financing. As such, bonds are backed by the issuer’s property, making investing safer. When an entity offers a bond, it promises to repay the original amount on a particular date known as the maturity date and pay the loan amount plus interest a fixed number of times in a year.

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Debentures

Debentures are instruments of external finance offered by private companies and can be redeemable or irredeemable. While debentures are a form of debt, they are not secured by tangible assets or personal property like bonds. Instead, they depend on the ability and standing of the company providing the loan to repay the debt. Due to these, debentures are generally more risky than bonds since they are unsecured.

What is Difference Between Bonds and Debentures?

It often needs clarification to understand, ‘what is the difference between bond and debenture?’ Bonds and debentures are both fixed-income instruments that are used to finance the activities of a company with the help of outside investors who are interested in getting back a fixed amount of money along with a fixed percentage of interest in return on their investment over a definite period that has been mutually agreed upon.

A quick difference between bond and debenture for better understanding:

Feature Bond Debenture
Security Secured or Unsecured Unsecured
Collateral Often backed by collateral (assets) of the issuer Not backed by any physical assets
Risk Generally lower risk due to collateral backing Generally higher risk due to lack of collateral
Interest Rate May offer fixed or floating interest rates Typically offer fixed interest rates
Maturity Typically have longer maturity periods (e.g., 5-30 years) Can have shorter or longer maturity periods
Issuer Issued by governments, corporations, and financial institutions Issued by private companies
Purpose Raise capital for long-term projects or funding needs Raise capital for various purposes, often expansion or specific projects
Payment Priority Bondholders receive interest and principal repayment before shareholders Debenture holders receive interest payments before shareholders, but after bondholders (if applicable)

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Bonds Vs Debentures

The main components of difference between bonds and debenture include:

Collateral and Security

The primary distinguishing feature of bonds and debentures is the provision of security. Bonds are usually backed by an indenture, which means that a specific property of the issuer will act as security for the bond. This kind of collateral backing makes bonds safer for investors, particularly in financial turmoil for the issuer.
On the other hand, debentures are typically provided without any such collateral or security. They have no tangible security that they can pledge to the lenders. Instead, debenture holders rely on the company’s corporate credit standing or reputation to issue the debentures.

Interest Rates

Interest rates are another critical factor that distinguishes bonds and debentures. Bonds usually have a lower interest rate because they are secured and involve lower risk than other securities. The coupon can be fixed and floating based on the contract signed between the bond issuer and the buyer. These interest payments are made at specific intervals like “more often, semi-annually or annually.

Since debentures are unsecured, they are floated at relatively higher interest rates to attract investors apart from having collateral risks. The rate of interest on debentures can also be fixed or floating. These are made at regular intervals and often do not depend on the company’s performance, meaning that debenture holders will receive interest payments if the company is solvent.

Priority in Liquidation

It is essential to understand that in the unfortunate circumstance of the liquidation of a firm, the order of debt repayment is quite crucial. Before paying the debenture holders with the proceeds of the project, the bondholders are paid first in the repayment process. It implies that any payments to debenture holders will be made after bondholders have been paid from the proceeds of the liquidation process.

On the other hand, bondholders have priority over debenture holders and are paid first in the event of a liquidation. This lower priority makes debentures higher risk because there may be more assets to satisfy the debenture holders after paying off the bonds and most secured creditors.

Payment Structure and Tenure

Bonds are long-term financial instruments in the market, commonly with a maturity period of several years or more. The payments on the bonds can be of different types. Still, often, they can include interest in a certain period “for example, monthly, semi-annual or annually, and payment of the nominal value of the bonds at the end of the term.
They are often issued for shorter terms than bonds but may also be issued for long terms. Debentures are paid at regular intervals and can be fixed at the time of the issue of the debentures. Debenture interest is usually paid from the profit earned by the company and is, hence, variable compared to bonds.

Convertibility

Another area of difference between bonds and debentures is convertibility. Bonds are usually non-convertible securities which remain as debt securities in the company’s balance sheet and do not hold the possibility of being converted into equity shares. This characteristic ensures that bondholders remain creditors of the issuing entity at all times.
Different debentures can be issued, such as convertible debentures and non-convertible debentures. These are debentures with the features of being convertible into equity shares of the issuing company after a fixed period or on certain specified conditions. This can be useful for investors seeking an opportunity to have an equity stake in the firm even though they first purchase a debt security.

Risk and Return

The risk and return factor is another significant way in which bonds differ from debentures. Stocks are considered a less secure investment because of their higher default risk than bonds. The fact that most bonds are secured and ranked by collateral backing and priority in cases of liquidation minimises the bondholder’s risk. Due to this, the returns obtained from bonds are usually less than those from debentures.

Debentures are less secure than the other types of bonds and, therefore, have more risk. This increases the risk and is balanced by the prospect of receiving higher returns. Debenture holders receive higher interest relative to bondholders since debentures usually present a relatively higher default risk.

Tax Implications

Another factor that may affect the choice between bonds and debentures is taxes. Interest income under both bonds and debentures is generally subject to tax. However, some types of bonds, particularly municipal bonds, extend tax benefits where they are free from federal and sometimes state income taxes.
There are no unique tax benefits that may accompany the ownership of debentures. The interest received from debentures is also charged at the standard income tax rates. Investors should also consider the impact their investment decisions have on their taxes and consult tax experts in this matter.

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Regulatory Environment

Public and corporate bonds are generally very tightly regulated to ensure that the investors are well protected. These regulations enhance the level of transparency and accountability in the project to avert fraud and default. The regulatory oversight can also increase investor confidence in bonds.
Sometimes, debentures, especially privately placed debentures, may be offered and sold with fewer legal requirements. Whereas public debentures listed on the stock market may be regulated, privately placed debentures may need to be more closely scrutinized. These different regulations can affect the perception of investors as well as the risk related to debentures.

Conclusion

To invest correctly, learning the difference between bond and debenture is essential. Bonds, as being secured and involving comparatively lower risk, are safer investments for investors with low-risk tolerance. It is up to the investor to determine which of the financing instruments i.e., “bonds or debentures “is preferable depending on his risk diversified and financial priorities and the offer of the securities he is going to invest in.

For more information and to gain more knowledge on ‘what is the difference between bonds and debentures’, visit SMC Global Securities. SMC Global Securities offers a comprehensive suite of investment products, including a wide range of bonds and debentures. Our experienced advisors can help you understand your risk tolerance and develop an investment strategy tailored to your needs.

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Reference : 

https://efinancemanagement.com/sources-of-finance/bond-vs-debenture

https://insider.finology.in/investing/difference-between-bonds-and-debentures

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