For simplicity and understanding, bonds and debentures can be compared to unsecured and secured loans. That’s the prime difference that can differentiate between a bond and a debenture.
Both bonds and debentures are issued by large corporations and Government institutes to raise funds. With some variation in features, debentures are termed as one type of bond.
Broadly speaking, these are debt instruments paying interest (coupon) to the lenders (investors). These instruments are issued by large entities, private and public, which make these debt instruments secured investments.
The interest paid on these instruments is often lower than other risky investments, but higher than bank deposits.
Here are a few of the characteristics of bonds and debentures that can differentiate between the two.
1) Bonds are Secured Debts:
Bonds are almost certainly issued by entities backed by collateral. Debentures can be secured or unsecured debts, but normally are issued without collateral.
Private companies issue debentures on reputation and offer higher interest rates than bonds to attract investors. Investors look for issuer credit ratings that also work as a key demand-supply factor and affect the secondary market pricing of bonds.
Some bonds are also offered without collateral, for example, US treasury issued bonds are not backed by any collateral. Bond issuers are mostly Government and large financial institutes, which makes bonds the most secured debt instruments.
2) Debentures can be Convertible:
Bond and debenture issuers make guaranteed repayment of principal amounts. Bonds are non-convertible to equity. Debentures are sometimes paid back with company shares, called convertible debentures.
Investors often look for convertible debentures, to take advantage of low-risk investments first and higher returns later. This feature of debentures makes them higher marketable security than bonds.
The Issuer of debentures can convert the repayment loan fully or partially to equity. As private companies look to fund special projects with debentures, the convertibility can be risky for investors.
3) Coupon Payment Rates and Structure:
As deemed more secured debt instruments, bonds offer lower returns than debentures. Also, companies often issue debentures to fund business expansion or a particular project making debts riskier.
Investors look for higher rewards with debentures, these rewards can be higher coupon rates or convertibility features to shares.
Bonds and debentures come with both floating and fixed interest rates. As debentures are riskier than bonds, they offer usually higher coupon payments than bonds.
The repayment terms with bonds remain more secured than debentures. As bond issuers are mostly Government-backed institutes, the repayment doesn’t get affected by issuer performance.
Contrarily, returns of debentures do depend on issuer performance. Particularly in the case of convertible debentures, project success plays a key role in repayment terms.
From the investors’ perspective, the unsecured nature of debentures offers higher interest than bonds. Also, debentures offer higher liquidity in the secondary markets due to the convertibility feature.
4) Risk and Liquidity:
Hands down bonds are less risky investments than debentures. Bonds are secured by collateral and issuer reputation. Even bonds without collateral such as US Treasury-issued bonds are deemed secured debt instruments.
Debentures are issued on issuer reputation and goodwill without collateral. Debentures also get affected by issuer performance, particularly, in the case of project issued debentures.
Bonds are often offered below par or face value that creates an opportunity for investors to sell the bonds before maturity. Higher interest rates and convertibility feature also makes debentures marketable and liquid instruments. Investors often look for short-selling to realize quick gains rather than relying on coupon payments.
5) The Bankruptcy of Issuer:
In the unlikely event of bankruptcy of these debt instruments, bondholders take priority before debenture holders. Debenture holders take priority before other shareholders though. However, both the debt instruments are considered highly secured investments.
6) Investors’ Choice between Bonds and Debentures:
Any financial advisor will advise you to put bonds in your investment basket. As an investor, if you’re looking for long-term capital gains bonds are the right choice for you.
Convertible debentures with higher liquidity can be traded quickly on the secondary markets to make quick gains. Depending on the issuer, holding convertible debentures to maturity can offer higher rewards with company converted shares.
Investors such as in post-retirement age looking for safer investments with regular payments should choose bonds as a preferred investment choice.
The Bottom Line:
Theoretically, there is little to differentiate between the bonds and debentures. Both are secured debt instruments, issued by large financial institutes with high creditworthiness.
Both instruments offer low-risk and secured investment options. Both bonds and debentures are considered secure long-term investments. In practical terms, the issuer creditworthiness and the debt instrument return-reward terms can be the best guide to choose between bonds and debentures.