Investing in bonds and debentures is becoming popular, and many companies are taking part .Whether it is a micro-enterprise, government, or an established firm, they all need money for their daily operations. All these institutions are in business to generate revenues. With time, they use borrowing as an alternative way to raise funds.
Once the financial situation stabilizes, investors are paid back their capital. Furthermore, your will receive your principal amount with interests after the agreed period. Let us explore their fundamental differences and similarities.
Definition of a Bond
Bonds are secured financial instruments that represent the obligation of a lender on a borrower. A certificate is issued as a sign of commitment from the borrower to settle the borrowed sum later.
Bonds can also be termed as secured investments since they are guaranteed using collaterals. These collaterals can be in the form of assets. If the issuer fails to pay the bondholder, the assets are sold to recover the debt.
Bonds have a fixed issuance period. During the agreed period of issuance, bondholders receive coupons. They (coupons) are interests paid on the bonds. For example, you have bought a bond worth $ 10,000 for 10 years with an interest rate calculated at 10%. Your interest will be computed as follows.
This means you will be receiving a coupon of $ 1,000 every month. After the issuance period matures, you will receive your principal amount of $ 10,000.
Bonds are termed safe investments with an assured return. Most financial experts advise their clients to secure part of their assets in bonds. This part should be increased yearly, especially when approaching the retirement stage.
Definition of a Debenture
Debentures are bonds in nature. Public companies and large multinationals use debentures for fundraising capital. These monies will be used to service operational expenses. Additionally, debentures raise funds for a future project or cater to a scheduled business expansion.
Debentures are unsecured debt instruments. Hence, they are not supported by collaterals. The borrower is expected to repay the loan from the earnings of the project financed. Additionally, investors rely heavily on the credit ratings of the borrower to act as the security. In such cases, debentures are called revenue bonds.
Most corporations prefer debentures for long-term financing. As the borrower, you can decide to pay the principal in installments or lump sum on the debenture's maturity date. This approach will mean a calculated sum is paid periodically until the loan is paid fully.
Categories of Debentures
Debentures exist in two major categories: Convertible and non-convertible debentures.
A company may decide to allow the gaining of shares. In such an arrangement, investors can convert their investments into corporation shares. Typically, this is a lucrative option for companies to gain more trust from their investors. Moreover, investors benefit by gaining equity in the corporation.
Alternatively, a company can force investors to convert your debenture into corporation shares. A company can allow its investors to gain convertible shares by converting a portion of its debentures into equity. The remaining amount will be retained and redeemed upon maturity.
Convertible debentures pose a risk to both the issuer and the financier. For the corporation, the significant risk is allowing the debentures to be converted to corporation shares. This can quickly reduce the company ownership rights.
In this type of debenture, an investor is not allowed to gain equity. The debentures are fixed, and you only receive interests periodically. You will receive the principal once the debenture matures.
You can still decide to buy off the liabilities of a new business. Nevertheless, there will be no assurance of shares when the debenture matures.
As an investor, you will likely suffer a capital loss if the company owners declare bankruptcy or liquidate it. You may receive your funds, but it may take longer since the priority goes to the payment of secured liabilities.
Similarities Between Bonds and Debentures
1. Both Are Sources of Debt Financing
Government agencies widely use both instruments as external sources of finance. In addition, multinationals and public companies use them to raise funds. Usage of both financial instruments is an excellent way to finance long-term projects.
2. Payment is Periodical
Debenture holders receive periodical interests as debenture redemption reserves. The principal is paid upon maturity of the issuance period. Also, bondholders receive coupons on accrued terms. Investors could choose to receive accrued interest upon maturity. The borrower later pays this interest together with the principal amount upon maturity.
The Key Differences Between Bonds and Debentures
Most investors often interchange the two terms. Below are the critical differences.
Debenture holders have reported receiving a higher interest rate compared to bondholders. The main reason behind this is that debentures are unsecured loans, posing more risks to the investors than bonds.
Furthermore, risks have a direct relation to returns. A risk is defined as a factor limiting the guarantee of expected return. The higher the risk, the higher the anticipated return, and vice versa.
Bonds are secured with low risks hence attract a low interest rate. Also, bonds have a high stability rate for settlement.
A bond is considered a secured financial instrument. Furthermore, a bond is attached to collateral, while debentures lack securities. Whenever an issuing company fails to pay the principal or bond coupons to its investors, it can raise the required sum by selling its securities.
Debenture holders are not guaranteed a spot on cash since the loan is unsecured. In this case, investors only rely on the company's credit ratings when investing. Notably, you cannot consider credibility as a saleable item in an open market as an investor.
Not all debentures that are secured have collaterals attached to them. Such agreements are rare and solely depend on the corporation issuing the instrument. Ensure you consult your financial expert to guide you in your investment.
Convertibility to Equity
Debentures exist in two forms convertible and non-convertible. With convertible debentures, you can convert a portion of it to company stocks. Companies can never convert bonds to equity. They are secured and can never become part of equity while the contract is still on. Notably, all shareholders have equal rights.
Debenture holders are prone to high default risk compared to bondholders. Unlike debentures, bonds are purely secured hence attracting minimal risks. Debentures are unsecured, and the holders solely rely on the credit ratings of the company.
Liquidation or Bankruptcy Priority
Bankruptcy occurs when a company lacks sufficient resources or assets. These assets are regarded as securities for settling all its financial obligations.
A company can declare itself bankrupt or file for bankruptcy in a court of law. The court or shareholders can appoint a certified liquidator to sell all the company's assets. The proceeds from this transaction will be used to offset its liabilities.
Upon the successful sale of the company's assets, the priority list of the payment goes to bondholders. They are paid first because they have secured liabilities. Debenture holders receive payment last due to unsecured obligations.
Debenture holders will have to wait longer before they receive their pay. This priority decision will likely cause panic within the debenture holder factions. This could lead to unrest due to uncertainties on the exact date of payment.
In most cases, bonds are issued by financial companies, government, and state corporations. On the other hand, public and private companies issue debentures.
Bondholders receive payments monthly or annually. Interest or coupons is usually paid on accrual terms, and the amount is not dependent on the performance of the market in that financial year.
Debenture holders receive payments periodically. This amount often fluctuates with the company's market performance in that period. The amount may further reduce due to taxation policies imposed by authorities.
Bonds are long-term financial instruments with a guaranteed repayment. Debentures can fit into short-term and long-term investments, but this depends on the issuer.
With the similarities and differences mentioned above, you can choose to invest in either options .Go for an instrument that will give you value for your money. All these choices are dependent on your financial goals and abilities.
Do due diligence and weigh each investment's pros and cons before putting your money. You can get recommendations from your colleagues or friends on either financing instrument. Use their reviews to make an informed decision on your preferred financial instrument.
Alternatively, you can consult a financial expert on either instrument before investing. Go for a certified broker with a proven track record to handle your investment portfolio.
Both bonds and debentures are forms of debt financing instruments. They are differentiated using their existing nature. Bonds are usually secured with collaterals, while debentures are unsecured.
However, lack of security for debentures does not mean investing in debentures is riskier than bonds. Most government bonds and treasury bills are unsecured. Nevertheless, we still consider them risk-free investments.