Bonds & Debentures: Meaning, Types & Differences

Bonds & Debentures: Meaning, Types & Differences

Raising funds is the basic requirement of every organization or companies. Funds can be raised by issuing debt or equity instruments and for that, two major sources of raising external finance are used by the companies. These are called Bonds and Debentures. Bonds are generally issued by government agencies and large corporations while, companies issue debentures to raise money from the market. The major difference between these two debt instruments is bonds are more secure as compared to debentures.

Let’s see in detail.

What are Bonds

A bond is debt instruments issued by a government or a company to borrow funds from individual or corporate investors for a specific duration. In return, the issuer offers periodic interest to the holders.

In general, bonds are secured by collateral, i.e. an asset is pledged as security that if the company fails to pay the sum within stipulated time, the holders can discharge their debts by seizing and selling the asset secured. These securities have a face value which is their redeemable price. Also, the issuer provides coupon payments to the holders throughout the holding period.

Such funds are treated similarly to loans and have a principal sum (issuance value), interest (coupon), and loan term (maturity period). Most of them offer a fixed interest rate at regular intervals, i.e., monthly, quarterly, semi-annually, or annually. But some have floating rates as well, though they involve higher risk.

Types of Bonds

A bond can be of multiple kinds based on its issuing party, coupon payment, flexibility, yield, etc.

• Fixed Rate Bond: These instruments have coupon rates that remain constant throughout their life.
• Floating Rate Bond:These are volatile, hence are classified as floating. The coupon rates of these securities are linked to a reference interest rate, such as the LIBOR (London Interbank Offered Rate) or U.S. Treasury Bill rate.
• Corporate Bonds: These are issued by the companies and sold to various investors. They can be secured or unsecured. The backing for them depends on the payment ability of the company, which in turn is linked to possible future earnings of the company from its operations.
• Government Bonds: These are issued by the national government promising to make regular payments and repay the face value on maturity. The terms on which the government can sell such securities depend on its creditworthiness in the market.
• Municipal Bonds: These debt instruments are released by the nation, state, or cities to raise finances for their upcoming or running projects. The income from such securities is exempted from the state and federal tax liabilities.
• Zero-Coupon Bond: They do not pay any periodical interest during their life. Instead, they are usually issued at a discount to the par value, making it an attractive investment. This difference is then rolled up, and the entire principal amount (par value) is paid on maturity.
• High Yield Bonds: Also known as junk bonds, and are rated below investment grade by the credit rating authorities. So, to attract investors, the issuers offer a higher rate of return. Since these are lower-grade instruments, they are expected to offer a larger yield. Investors willing to take a risk for higher yield opt for them.
• Convertible Bonds: Since it allows the holders to exchange them for specific equity shares, these are considered hybrid securities as they possess combined features of equity as well as debt.
• Inflation-indexed Bonds: These debt instruments link the principal and the interest amount to the inflation indexes like the consumer price index. Thus, they protect investors from inflation prevailing in the economy, thereby securing their investments.
• Subordinated Bonds: These are a class of unsecured corporate debt securities that have a lower priority than other instruments at the time of liquidation. The risk is higher than senior bonds. Once the creditors and senior bondholders are paid, the subordinated bondholders are compensated. Comparatively, they have a lower credit rating. Some examples of them are the debt instruments issued by banks, asset-backed securities, etc.
• Foreign bonds: These are issued by a foreign company in the domestic market in order to raise funds in the domestic currency. As most investors would be from the domestic market, it can benefit from a diversified portfolio. Moreover, the investors can also get foreign exposure in their respective portfolios—for instance, Bulldog and Samurai bonds.

What is Debenture

The word ‘debenture’ is derived from Latin word ‘debere’ which means to borrow or loan. Debentures are written debt instruments that companies issue that means debenture holders become creditors of the company. This instrument carries date of redemption and amount of repayment as mentioned on it. Debentures are issued to the public as a contract of repayment of money borrowed from them. The amount borrowed is to be repaid at the end of the stipulated term, as per the terms of redemption.

A company thus have advantage of secure way of raising money, less risk of dilution of equity, and have option of redemption. On the other hand, Debenture holder can enjoy a secured way of investing money, fixed rate of interest and also right to charge in case of secured debentures.

Types of Debentures

Based on security, convertibility, tenure, registration Debentures may be:

• Secured Debentures:As the name suggests, these are secured against assets of the company, also known as mortgage debentures.
• Unsecured Debentures:Unlike secured debentures, these are not secured by any charge against the assets of the company, neither fixed nor floating. Hence lender usually is at high risk of losing his principal in case the company defaults. Though, this type of debenture has a high rate of interest.
• Convertible Debentures:These debentures can be converted into equity shares at the option of the debenture holder and thus, he will become a shareholder.
• Non-Convertible Debentures: Such debentures do not have an option to be converted to shares or any kind of equity.
• Redeemable Debentures: These debentures are payable at the maturity of their term with principal and interest on them.
• Irredeemable Debentures:Such debentures are perpetual in nature and don’t have fixed date at which they become payable.
• Registered Debentures: Here the company is required to maintain a register of its debentures holders as section 88 of the companies Act,2013. Both, the debenture certificate and the company’s register, shall have the name of debenture holder.
• Bearer Debentures: Here registration is not required. Such type of debentures are transferable by way of simple delivery and are also called debentures payable to the bearer.

See also….
What is Systematic Investment Plan (SIP)?