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What is the difference between debentures and shares?

Writer # Shantanu Kurup | January 17, 2024

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Introduction

Imagine being the owner of a thriving ice-cream company. Your brand has become a sensation, captivating the hearts of numerous customers who simply can’t get enough. However, a competitor has emerged in your niche, necessitating an increase in marketing expenses. Additionally, it’s time to upgrade your mixing machine and freezers, and there’s a surging demand for your brand in another city. To address these challenges and facilitate mass-level operations and expansion, securing funds is crucial. In this scenario, you have two primary options: Firstly, consider selling a percentage of your ownership in the company. Alternatively, you could opt for a loan to finance the required investments. Making this decision involves weighing the pros and cons. Selling ownership means giving up control but might be more financially viable than taking on additional loans. On the other hand, opting for a loan allows you to retain control but could add to existing financial burdens. Companies encounter these circumstances periodically and make decisions, such as whether to take loans or issue shares, based on their capital structure and various other factors. As an investor, you may find certain decisions puzzling at times, leaving you to contemplate the nature of these corporate choices and their implications for you. Shares and debentures (loans) stand out as crucial asset classes in the arena of financial investments. Therefore, it is imperative for you to comprehend the nitty-gritties of this concept to become a well-informed investor. If you have consistently grappled with these terms, no need to fret; this article will decode the concept and highlight the distinctions between shares and debentures in the simplest manner possible.

What is a debenture?

A debenture or a ‘bond,’ represents loans issued by a company seeking funds from investors. These loans come with a specified maturity period. In exchange for these loans, the company committing the debentures pledges to provide fixed cash flows, known as ‘coupon’ payments, to the investors. Additionally, upon reaching maturity, the company repays the original principal amount to the investor. Holding a debenture designates you as the debenture holder, establishing you as a creditor of the company. As a creditor, the company is obligated to prioritize the interests of debenture holders, granting them precedence, notably during liquidation. This prioritization applies even if the company is not generating profits, as timely payments to debenture holders must still be fulfilled. Now primarily there are two types of debentures:

A. Convertible Debentures
Convertible debentures are like special debentures a company offers. If you lend them (companies) money, they promise to pay it back with interest, just like a regular loan. But the twist with convertible: you also get the option to convert that loan into shares of the company later on, sort of like becoming a part-owner. It’s like having a loan with a potential bonus of turning into stocks, giving you the best of both worlds.

B. Non-convertible Debentures
Non-convertible debentures are like straightforward loans that a company takes from you. When you lend money by buying these debentures, the company agrees to pay back the borrowed amount with fixed interest over time. However, unlike convertible debentures, there’s no option to turn this loan into company shares. So, it’s a clear deal – you lend money and in return, you receive regular interest payments until the agreed-upon maturity date when the company repays the loan.

What is a share?

In its most basic form, a share signifies ownership, also referred to as equity or stock. When you invest in a company’s shares, you essentially become a partial owner of the company proportionate to the amount you’ve invested, making you a shareholder. As a shareholder, you have the right to share in the company’s profits and bear its losses. Additionally, you gain a say in the corporate decisions of the company. If the company experiences growth, its earnings increase, potentially leading to a rise in stock prices and capital appreciation for you as an investor.

There are two main types of shares:

A. Common Shares
Common shares are like owning a piece of a company. When you buy common shares, you become a shareholder, which means you’re a part owner of that company. As a common shareholder, you have the right to vote (voting rights) on certain decisions the company makes at shareholder meetings. While common shareholders may receive a share of the company’s profits, called dividends, the amount can vary and it’s not guaranteed. If the company faces financial trouble and has to sell its assets, common shareholders are the last in line to get a share of the money, after all debts are paid.

B. Preference Shares
Preference shares are another type of ownership in a company, but they come with some extra perks. As a preference shareholder, you have a higher claim on the company’s assets and earnings compared to common shareholders. You typically receive fixed dividends and these are paid out before any dividends go to common shareholders. If the company needs to liquidate assets due to financial difficulties, preference shareholders receive their investment back before common shareholders but not before debenture holders. However, preference shareholders usually don’t get to vote on company decisions like common shareholders do. So, while they enjoy more predictable returns, they miss out on some of the decision-making power.

Difference between debentures and shares

FeaturesDebentureShare
MeaningIt represents creditorship owed by the companyIt symbolizes ownership in a company
ReturnsFixed interest payments are made regardless of whether the company generates profits.Dividends are not guaranteed and are distributed only when the company earns profits.
RiskRelatively lower risk, as returns are fixedHigher risk, as returns are variable
Voting RightsTypically, no voting rightsCommon shares have voting rights
Claim on Assets in
case of liquidation
Debenture holders have a higher claim on company assets compared to shareholdersLast in line during liquidation
IncomeInterestDividend
ConversionConvertible debentures can be converted into sharesCannot be converted into debentures

Conclusion

As a retail investor, when it comes to the difference between shares and debentures, the decision between opting for either shares or debentures primarily hinges on your individual financial goals and preferences. Shares, or stocks, facilitate wealth accumulation, while debentures play a role in preserving that wealth. Ultimately, the choice between becoming a company owner (through shares) or a creditor (through debentures) rests on your ability to identify and align with your financial objectives. Considering risks, both asset classes—debentures and shares—carry inherent uncertainties. For debentures, the creditworthiness of the issuer is paramount. Credit rating agencies evaluate and assign ratings to the debentures, indicating the likelihood of repayment. Higher-rated companies may offer a reasonable return, while lower-rated ones may provide a relatively higher return to compensate for increased risk. In the case of equity, shares are actively traded on the stock exchange and their prices are influenced by factors like demand, supply, economics and market sentiment. Therefore, exercising caution and conducting thorough analysis is crucial before venturing into the world of financial investments.

Risk is an inevitable aspect, even when considering the seemingly secure option of a ‘Fixed Deposit.’ All individuals are exposed to various types of risks, but this should not discourage you from making investments. Financial products are designed to help you attain your financial objectives. To navigate these risks successfully, it is essential to conduct thorough research, align your financial goals with the appropriate products through asset allocation and become financially independent.

FAQs

Q. What is the primary difference between shares and debentures?

A.  The primary difference between shares and debentures lies in their nature and the rights they confer to the holders. Shares represent ownership in a company with voting rights, dividends, and a claim on assets (after all creditors are paid). Debentures are debt instruments, offering fixed interest payments and priority in asset claims, but no ownership or voting rights.

Q. What is the difference between bonds and debentures?

A. Well, they are essentially the same but used in different contexts. For instance, if loans issued by the government, they are termed as bonds and if issued by private entities, they are termed as debentures.

Q. Does a debenture holder have a say in corporate decisions?

A. No, the debenture holder, unlike the shareholder, is not a part owner and therefore does not receive the benefits of voting rights or dividends. As a creditor, you have the right to fixed interest and will be prioritized before the preferred and common equity holders.

Q. What are the types of debentures?

A. Debentures come in various types, each with its own characteristics. Here’s an overview:

Secured Debentures: These are backed by specific assets of the issuing company. In case of default, debenture holders have a claim on the collateral.

Unsecured Debentures: Also known as naked debentures, these are not backed by specific assets. Debenture holders rely on the company’s creditworthiness.

Redeemable Debentures: These have a fixed maturity date and the principal amount is repaid to the debenture holders on or before that date.

Non-Redeemable Debentures: Also known as perpetual debentures, they do not have a maturity date. The issuer is not obligated to repay the principal as long atyps the company is in operation.

Q. Debentures vs shares; which is better?

A. The choice between debentures and shares depends on the investor’s preference. Debentures offer steady income and security for creditors, while shares provide ownership and potential for capital appreciation. It’s a matter of income stability (debentures) versus growth potential and ownership perks (shares), based on individual goals and risk tolerance.

Disclaimer: Investments in debt securities are subject to risks. Read all the offer related documents carefully.