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When the government raises funds, there is no concept of sharing ownership with investors. They use debt financing in such cases.
While equity makes the investor a part owner, debt treats the investor like a lender.
Debt is a form of loan that corporations and the government borrow from the public in exchange for interest payments and a promise to repay the principal after the agreed term.
Debentures and bonds fall under the purview of debt securities.
What are bonds?
Bonds are securities issued by the government and corporations in the form of debt, to meet their financial needs.
Investors here play the role of lenders, and the corporation or government issuing the bonds are borrowers.
Bonds are usually secured loans as they are secured by physical assets.
Features of bonds
- Interest rate – Bonds involve interest payment. A fixed percentage calculated on the face value is paid as interest at regular intervals.
- Issue price and face value – Issue price is the price paid by the investor while purchasing the bond. Face value is the price the issuer pays back during redemption.
- Maturity date – This represents the term or duration of the loan. The principal must be returned after the bond matures.
- Yield – The total return an investor earns upon investing in the bond.
- Liquidity – Bonds are traded on the stock exchange. It is essential to understand how easy or difficult it is to sell a particular bond in the market.
How to invest in bonds?
Corporate bonds to raise capital are first issued in the primary market, where investors can directly buy them from corporations. Further trading of these bonds takes place in the secondary market.
Bonds issued by the state and local government authorities are called Municipal bonds. Investors can buy these from the primary market during a specific time allocated for retail investors. They can also buy it from the secondary market after creating a DEMAT account.
Investors must open an account in the Retail Direct Gilt (RDG) portal to buy bonds from RBI Direct.
What are debentures?
Debentures are one of the types of bonds issued by corporations and the government.
These are unsecured loans as they do not have any collateral attached.
Debenture holders cannot exercise any right over the company’s assets. Investing in debentures is based on the creditworthiness of the issuer.
Features of debentures
- Secured debentures – While the normal debentures are not collateralised, only the secured debentures have collateral.
- Unsecured debentures – These are the regular debentures which are not secured. The creditworthiness and goodwill of the company play critical roles in attracting investors.
- Redeemable debentures – These debentures are valid until the maturity date, after which they are redeemed.
- Irredeemable debentures – These debentures do not have a maturity date. They will be redeemed only during the company’s liquidation.
- Convertible debentures – Some debentures can convert into equity after a specific time.
Based on the conversion, they are further divided:
- Partially convertible – A portion of the total debentures can be converted to equity. The issuer decides the quantity and date of conversion.
- Fully convertible – All units of the debentures can convert into equity.
- Optionally convertible – Conversion into equity based on the issuer’s decision.
- Non-convertible debentures – These will remain debt securities throughout their term and will not be converted into equity.
How to invest in debentures?
Debentures can be bought directly from the issuer – corporations or government. Debentures are traded in the secondary market hence, they can be bought on the stock exchanges as well.
All debentures, except secured debentures, are unsecured. Similarly, all debentures, except convertible debentures, are non-convertible.
Difference between bond and debenture
| Bonds | Debentures |
| Bonds are secured loans against collateral. | Debentures are unsecured loans and are not supported by any collateral. |
| Bonds are less risky. | Debentures have a greater risk involved. |
| Bonds are generally for a longer term than debentures. | The maturity period of debentures is shorter than that of bonds. |
| Bonds offer a lower rate of interest as they are secured loans. | Better interest rates than bonds as debentures are riskier. |
| Bondholders get priority in interest and principal payments in cases of liquidation. | Debenture holders stand after bondholders in the event of liquidation. |
Bottom line
Large corporations and governments issue debt securities like bonds and debentures to raise money.
Though investors do not get the benefits of an equity shareholder, debt securities are more stable in generating recurring income for investors.
FAQs
Yes, since debentures are debt instruments, investing in them is often less risky than buying common stock or preferred shares of the same business. In the event of bankruptcy, holders of debentures would also be prioritised over holders of those other types of investments.
It depends on what one prefers, judging by the different characteristics and benefits offered by debentures and fixed deposits. Debentures offer potentially higher earnings, but they have longer maturities and greater risk. On the other hand, fixed deposits offer shorter maturity periods, stability, reduced risk, and predictable profits.
One kind of fixed-income investment is a tax-free bond, in which the interest paid to bondholders is not subject to income tax. Governmental organisations, municipal corporations, public sector initiatives, and other infrastructure companies are the issuers of these bonds.
Bonds are taxable on maturity if they have capital gains. However, a capital gain (or loss) is often not recognised if you purchased the bond at the time of issuance at the issue price and kept it until maturity. You probably won’t pay any capital gains tax as a result.
Your interest payments and face value aren’t going to change if you keep the bond until maturity; hence, the volatility won’t affect you. However, you should be aware that the amount you pay or get when buying and selling bonds is not the bond’s face value but the bond price.