Difference Between Bonds & Debentures

A loan is the most common method of obtaining the necessary funds. There are numerous ways to borrow money, but the two most common are bonds and debentures. These financial debt instruments have different functions and are issued to attract investment or money from you, i.e., the general public. All debentures are bonds, but not all bonds are debentures.

Let’s learn how bonds and debentures differ.

What is Debenture?

The most popular type of bond issued by private companies is debentures. Debentures are issued to raise money to pay for a forthcoming project’s expenses or business development. These debt securities are a popular type of long-term debt that businesses borrow.

Debentures can be either secured or unsecured.

Secured: When a debenture is secured, it is supported by collateral. To put it simply, you get some insurance against a loan.

Unsecured: An unsecured debenture carries a higher risk than a bond because there is no tangible asset backing it, and you must rely on the credit ratings of the company issuing it for security.

For example, the difference between a personal loan and a home loan where a personal loan does not require collateral but a home loan does. The interest rate on debentures may be fixed or variable. They give you a return on investment in the form of a variable or fixed coupon rate of interest. In the distribution of interest and dividend payments, being a debenture holder gives you priority over the shareholders of the corporation. Since debentures are not always backed by a company’s tangible assets, their interest rates are typically higher than those of bonds.

What are Bonds?

The most popular type of debt instrument is a bond which is a secured investment. Corporations, financial institutions, and government businesses distribute these instruments to you.

By holding bonds, you become the lender, and the issuer of the bonds becomes the borrower. Bonds serve as a form of promissory note between you and the borrower. You lend a sum of money with the promise that it will be reimbursed on or before the maturity date of the note. Most of the time, you will also qualify to receive ongoing interest payments for the bond’s term.

Bonds are frequently regarded as a relatively risk-free investment choice. As a company’s tangible assets serve as collateral for its bonds, the interest rate is typically lower than that of debentures.

Types of Bonds – By Issuer

In India, issuers of bonds vary widely and understanding these can significantly influence investment choices: Here are the types of Bonds:

Government Securities (G-Secs): The Government of India issues these types of bonds to fund developmental projects. The sovereign backing makes them the market’s most reliable and substantial segment.

State Development Loans (SDLs): These bonds fund state government projects and provide relatively higher returns than government securities. Each state’s different SDLs receive ratings based on their credit strength.

State Government Guaranteed Bonds:  State Government Guaranteed Bonds are bonds issued by state-owned entities and backed by a guarantee from the respective state government. These are primarily aimed at funding specific development projects, such as infrastructure. These bonds’ credit ratings mirror the financial health of the issuing state.

Public Sector Bonds (PSUs): Entities with majority government ownership issue bonds to finance sectors such as power and infrastructure. These bonds are popular due to their strong financial support. However, it is essential to note that PSU bonds do not carry any explicit government guarantee.

Corporate Bonds:  Corporate bonds, also known as Non-Cumulative Debentures or NCDs, are financial instruments issued by private corporations to raise capital. Investors who invest in these bonds are lending money to the company for a specified period. In return, they receive periodic interest payments. At the end of the bond’s term, the company repays the principal amount of the bond.

Bank Bonds: These bonds enable banks to raise capital for lending purposes and are among the most regulated issuances. Their risk and return profiles depend on the bank’s financial condition. Based on the bank’s balance sheet, these bonds can be categorized as either senior or subordinated, with the latter having subcategories including Tier 1, Tier 2 and Tier 3. NBFC Bonds: Non-Banking Financial Companies (NBFC) issue these bonds, which constitute a significant portion of the corporate bond market.

Different Types of Bonds – By Structure

Investors have access to all types of bonds based on their structure, offering flexibility in investment strategies:

Fixed Coupon Rate Bonds (Plain Vanilla): These types of bonds represent the most basic category and offer steady returns at fixed payment intervals, making them straightforward investment options.

Floating Coupon Rate Bonds: The coupon rates of these bonds are tied to benchmarks such as the interbank or SBI lending rates. The interest rates adjust based on market conditions, making them suitable for environments with rising interest rates.

Zero-Coupon Bonds (ZCBs): These types of bonds, known as ‘zero coupon’ bonds, do not pay any interest. They are issued at a price significantly below their face value and are redeemed at face value upon reaching maturity. Investors invest in these bonds at a discount and later receive the face value, earning a return from the difference between the purchase price and the redemption value.

Callable and Puttable Bonds: These types of bonds provide the option for either the issuer (callable) or the investor (puttable) to redeem the investment or retrieve their funds before the maturity date.

Subordinated Bonds: Primarily issued by banks, these bonds are subordinate to their ‘senior’ counterparts. Consequently, they carry a relatively higher risk and potentially offer higher returns (coupons) due to their lower claim in the event of issuer bankruptcy.

Perpetual Bonds: These bonds lack a maturity date but provide continuous returns, making them suitable for long-term investors. Additionally, they feature predetermined Call Dates when the issuer may choose to redeem the bonds.

Tax-Free Bonds:  Ideal for those seeking tax-advantaged investments, these types of bonds are often issued by entities affiliated with the government. The interest earned on these bonds is tax-free for the investor. They were introduced by the government to attract investors and raise significant capital for developmental needs.

Covered Bonds:  They are structured debt instruments backed by a pool of assets, with specific collateral assigned to each bond. This additional security makes them an attractive option for investors.

Principal Protected Market Linked Debentures: These bonds’ returns are tied to market indices or other benchmarks, offering variable returns. Capital Gain Bonds: Capital gain bonds, also known as 54 EC bonds, are issued by PFC, REC and IRFC. They offer significant benefits for those looking to avoid capital gains tax, serving as a strategic investment option following the sale of long-term capital assets such as land or property.

Types of Bonds Based on Credit Rating

Credit rating plays a critical role in assessing the risk associated with a bond. Bonds are classified into:

• Investment-Grade Bonds: These bonds have high credit ratings (AAA to BBB) and are considered low-risk. Issued by financially stable companies and governments, they offer steady returns.
• High-Yield or Junk Bonds: Rated below BBB, these carry higher risk but offer higher returns to compensate investors for taking on additional risk. Investors must assess risk tolerance before opting for these bonds.

Credit ratings help investors make informed decisions based on the risk-return profile of a bond.

Types of Bonds Based on Maturity (Term)

Bonds are also categorized based on their maturity periods:

• Short-Term Bonds: Mature in 1 to 3 years, offering lower yields but reduced risk.
• Medium-Term Bonds: Typically mature between 4 to 10 years, balancing yield and risk.
• Long-Term Bonds: Maturities extend beyond 10 years, offering higher yields but greater interest rate risk.

Key Differences between Bonds and Debentures

Where Should You Invest: In Debentures or Bonds?

If you are an investor with high-risk tolerance levels, you might consider investing in debentures. In unsecured debentures, due to the lack of any assets backing them, you must choose the company based on its trustworthiness and reputation for investment. When it comes to convertible debentures, they have a benefit. Here, you can exchange them for equity shares of the business. Debentures provide you with greater returns than bonds do.

Bond investments are ideal for you if you are an investor with a low-risk tolerance. Due to the guarantee of a principal and fixed interest payment after a certain amount of time, they are less risky. Bonds can provide you with a reliable source of income. They may be less risky, but you should still be aware of the inflation risk because it could lower the value of your assets.

Important considerations while choosing bonds and debentures

When deciding between bonds and debentures, investors should carefully assess a few key factors. The first is risk profile—secured bonds generally provide greater safety than unsecured debentures, but may offer slightly lower returns. The second is issuer credibility, since the financial health and reputation of the issuing company directly impact repayment ability. Investors should also evaluate the tenure and liquidity of the instrument to ensure it aligns with their financial goals. Another important aspect is tax treatment, as interest from bonds and debentures is taxable, and post-tax returns can vary. Finally, one must consider market conditions and interest rate trends, since they influence both yield and price movements. A balanced approach, combining safety with returns, can help investors make an informed choice between bonds and debentures.

Conclusion

It’s common to compare bonds with debentures. Bonds and debentures are two distinct debt products, albeit they may have certain similarities. Being constantly equipped with essential and accurate knowledge is the first step in avoiding investing hazards.

When selecting a financial instrument, you should base your decision on the returns you expect from investments. Equity are excellent for your long-term goals. Conversely, debt are appropriate for your short-term investments and are low-risk. Investing in debt and equity funds will help you diversify risk as a result making your short-term and long-term goals easily achievable.

FAQs

Q. What is the main difference between bonds and debentures?

A. Bonds are usually secured by collateral and generally offer lower interest rates due to reduced risk, while debentures can be secured or unsecured, often carrying higher interest rates due to their higher risk profile, especially when unsecured.

Q. Are debentures riskier than bonds?

A. Yes, unsecured debentures are relatively riskier than bonds because they are not backed by collateral. Investors in debentures rely on the creditworthiness of the issuing company.

Q. What are convertible debentures?

A. Convertible debentures are a type of debenture that can be converted into equity shares of the issuing company at a specified time, offering investors the potential for equity ownership in addition to interest payments.

Q. Which is better for low-risk investors, bonds or debentures?

A. Bonds are better for low-risk investors as they are secured by assets, providing stable interest payments and a guaranteed return of principal. Debentures, especially unsecured ones, are riskier and more suitable for high-risk investors seeking higher returns.

Disclaimer: Investments in debt securities/ municipal debt securities/ securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully.