This article has been authored by Anindita Deb, a BBA.LLB. student from Symbiosis Law School, NOIDA. In this article, the author discusses the differences between debentures and bonds along with the legal provisions governing both these financial instruments.
This article has been published by Sneha Mahawar.
Table of Contents
If you are an entrepreneurial enthusiast or have a keen interest in company law, you must know that debentures and bonds are indispensable financial instruments for any company. If an organisation requires funds for basic necessities, such as starting or expanding a business, borrowing is the most common method of obtaining the funds needed. Companies can borrow in a variety of ways, the most common of which are bonds and debentures. Debentures and bonds are both debt instruments that can be used interchangeably in many countries. They are, however, two distinct investment tools. Let us examine the distinction between bonds and debentures in this article.
Bonds are secured investments because they are backed by collateral. In bonds, an asset is pledged as collateral for lending so that if the issuer fails to pay the sum, bondholders can sell the asset to pay off their debts.
Bonds are issued for a specific period of time. A bond’s interest is paid at regular intervals known as coupons. A bond can occasionally be used as a regular source of income for retirees. The maturity date is the date in the future when your bond period will end.
A debenture is another type of debt security that is ordinarily unsecured. Bonds and debentures are both types of fundraisers, but debentures are more specific. Debentures are not backed by any of the issuer’s assets and thus rely solely on the investor’s faith in the issuer. The issuer issues debentures to meet a specific need, such as upcoming expenses or to fund expansions. Because the capital raised in the case of debentures is borrowed capital, the debenture holders are considered creditors of the company.
Mode of repayment
By choosing to buy a bond, you are making a loan to the issuer, who agrees to repay the face value of the loan on a specific date and to pay you periodic interest payments along the way, usually twice a year. Unlike stocks, corporate bonds give you no ownership rights.
On the due date, the company has two general options for principal repayment. They can pay in one lump sum or in installments. The installment plan is known as a “debenture redemption reserve,” and the company will pay the investor a fixed amount every year until maturity. The underlying documentation will include the debenture terms.
Government securities bonds
A debt instrument issued by the Central or State Governments of India is a government securities bond. Government securities (G-Sec), which primarily offer long-term investments between 5 and 40 years, include government bonds in India. State Development Loans are bonds issued by the state government.
These government securities were created by the Indian government to allow small investors to invest modest sums and earn interest while taking fewer risks. These bonds have semi-annual interest payments that can be either fixed or floating. However, the majority of government bonds are offered at a predetermined interest rate.
Companies issue corporate bonds to borrow money from investors for a specific period of time while charging them a predetermined interest rate throughout that duration.
Companies typically sell bonds to investors to fund new projects, expand their operations, or to grow in the future. Instead of getting a loan from the banks, the company seeks investors to invest their money in exchange for a particular rate of return over a defined period of time.
Investors receive the face value and interest rate after the term is over. Investors who wish to earn a guaranteed interest rate for the term of their investment prefer this type of bond.
These types of bonds provide both the benefits of debt and equity, but not simultaneously. The bondholders can convert this into a specified number of stocks, becoming shareholders of the company and receiving all the rewards provided to shareholders. After buying convertible bonds, investors can benefit from both debt and equity instruments.
This financial instrument does not pay interest, as the title indicates. It is also known as a “pure discount bond” since, until the bond matures, the investments do not yield a regular interest rate.
The face value of the bond, which is returned to the investor when it matures, is added with the annual returns on the principal amount.
This kind of bond is intended to mitigate the inflation risk of an investment that is mainly issued by the government and protects against inflation. Bonds that are linked to inflation find that their principal and interest rates change in relation to inflation.
The Floating Rate Savings Bonds 2020 (FRSB) that the RBI issues are also known as RBI bonds. These are 7-year taxable bonds with an interest rate that varies throughout the length of the bond’s term. As a result, rather than being paid at maturity, the interest rate is reset every six months, with the first reset being on January 1, 2021. When interest rates in the economy increase, the floating interest rate may increase as well.
Sovereign gold bonds
The central government issues these bonds to investors who wish to invest in gold but do not want to carry physical gold around with them. This bond’s interest that the investor receives is not subject to taxation. Given that it is offered by the government, it is also regarded as a highly secured bond.
After the first five years, investors who choose to redeem their investment may do so; however, doing so will merely change the date on which future interest payments are made.
Registered and bearer debentures
Debts may be registered to the issuer when they are issued as debentures. In this case, the transfer or sale of these securities needs to be coordinated through a clearing facility that notifies the issuer of ownership changes so they may pay interest to the appropriate bondholder. In contrast, a bearer debenture is not filed with the issuer. The owner (bearer) of the debenture is entitled to interest by simply holding the bond.
Redeemable and irredeemable debentures
The exact conditions and date by which the bond’s issuer must make a complete repayment of their loan is mentioned in redeemable debentures. On the other hand, irredeemable (non-redeemable) debentures do not oblige the issuer to repay in full by some deadline. These debentures can only be redeemed at the time of the dissolution of the issuing company. This is the reason irredeemable debentures are also referred to as perpetual debentures.
Convertible and non-convertible debentures
Debentures that are convertible have a fixed conversion period after which they can be converted into equity shares of the issuing company. These financial hybrid instruments combine the advantages of debt and equity. The debenture holders have the choice of either keeping the loan until it matures and collecting interest payments or turning it into equity shares. Investors who desire to convert their debt credited into equity are drawn to convertible debentures if they anticipate long-term gains in the value of the company’s stock. Convertible debentures pay a lower interest rate than other fixed-rate investments, so having the option to convert to equity has a cost.
Traditional debentures that cannot be changed into stock of the issuing company are known as nonconvertible debentures. Investors are rewarded with a higher interest rate compared to convertible debentures to compensate for the absence of convertibility.
Who should make the investment
Bond investments are ideal for investors with low degrees of risk tolerance. Compared to debentures, bonds are a safer investment. They are less risky since, after a specified period of time, principal and fixed interest payments are guaranteed. Additionally, because these securities are not backed by any collateral, investors are assured to receive payment when they mature. Bonds can therefore serve as a long-term investment choice for people who lack stock market experience.
Bonds often involve less risk. Investors should, however, take into account the danger of inflation, which could result in the investments losing value over time. Bond investments can also give investors a reliable source of income. By investing in these bonds, they are also able to diversify their portfolio.
Investors with high degrees of risk tolerance might consider investing in debentures. While the return on debentures is predictable, there is no assurance that it will be the same. Debentures lack any backing from collateral, making them riskier than bonds. Investors must therefore choose a company based on its creditworthiness and reputation for making sound investments. Debentures are also susceptible to changes in interest rates.
Debentures have a benefit when they are convertible. Here, investors can exchange them for company stock shares. Debentures also provide investors with greater returns than bonds do. They do come with some risk, though. In order to help investors diversify their investment portfolios, debentures might serve as a short-term investment choice.
Summary of differences
The following table helps summarise all the differences we have discussed above:
|Basis of difference
|Less risky than debentures
|Riskier than bonds
|Need to be backed up by collateral
|Most debentures come collateral-free
|Low-interest rate with high stability for repayment
|High-interest rate since not backed up by collateral
|Payments made on a monthly or yearly basis with no relation to the market performance of the company
|Payments made highly depend on the market performance of the company
|Mostly offered by government and financial institutions
|Mostly offered by private companies
Debentures and bonds are both debt instruments available for you to invest in. But it’s on you to decide if you want to be a risk-taker or play it safe. If you are the former type, bonds are your go-to option. But if you want to play with the stake, investing in debentures of reputed companies will fetch you attractive interest repayments and equity in the company. If you are new to the game, it is recommended that you start by investing in bonds and gradually explore investments in debentures. Either way, both debt instruments can be invested in after considering your options and the various factors such as interest rates, duration of repayment, etc.
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