Bonds vs. DebenturesDifferences You Need to Know Between the Two!

Written By:
Lisa Borga

For businesses, one of the most common financing tools available is bonds.

These tools allow companies to finance their operations and raise capital for growth.

The way a bond works is essentially that an investor provides the company with money under the agreement that it will be paid back at a fixed rate of interest over a specified period of time.

However, not all bonds are the same.

With most bonds, the promise to repay the investor with a fixed rate of interest is backed with physical commodities, which provide investors with a layer of security.

However, debentures are a specific type of bond that companies will often use to acquire the funding they need.

With debentures, the issuer does not back the loan with physical commodities meaning that it must rely solely on its reputation in convincing investors to purchase these debt securities.

Additionally, debentures may not have a fixed interest rate but may instead be floating.

How Debentures Are Different From Other Bonds

A debenture is a form of bond which is unsecured.

This means that it is not backed by assets such as land or machinery.

Instead, it depends upon the trust of investors who purchase the bond that its issuer will repay the debt.

As a result, they are often issued by the government or large companies with good credit ratings and healthy cash flow who are likely to be able to repay the debt.

A perfect example of this is U.S. Treasury bonds which are unsecured debts and, therefore, debentures due to the trust that investors have that the U.S. government will be able to repay its debts.

Though all bonds serve to raise capital when compared with other bonds, a debenture is more to be used for a specific intent such as meeting expenses for upcoming projects and expansions than other types of bonds.

Like other types of bonds, debentures possess an agreed-upon time for repayment; however, unlike other bonds, which typically have a fixed interest rate which means investors have a relatively predictable rate of return, debentures may have either a fixed or floating interest rate.

Though debentures are by nature less secure than other types of bonds that are backed by assets, these bonds are generally more secure than equity investments.

Essentially when interest payments are due, holders of debentures will be paid before shareholder dividends.

If a company was to go bankrupt, holders of secured debt would have their first stake in being repaid.

This is followed by holders of debentures and then shareholders.

Though debenture holders may have an earlier stake in being repaid compared with shareholders, they may still be left with nothing, unlike holders of secured debt.

Debentures are also often referred to as revenue bonds due to the fact that companies will often issue them with the intent to repay the debt using the additional revenue they helped to generate.

As with other types of bonds, debentures may be convertible.

This means that the investor may be able to convert them into equity shares.

These can be attractive opportunities for investors if they have reason to believe that the issuing company’s stock is likely to rise in the future.

However, this option comes at the price of lower interest rates. Finally, debentures can be bought and sold like any other type of bond

Bonds

Bonds are the most prevalent type of debt funding used by governmental entities and large companies.

A bond is essentially a loan agreement in which an investor pays the company issuing the bond a certain sum of money.

The issuer agrees to repay this money in addition to interest back to the investor by a specified date.

Over the period until the bond becomes mature, the investor will generally also be provided with regular interest payments.

When investing, bonds are thought to be one of the safer types of investments.

If the bonds are government bonds or issued by a corporation that is highly rated, there is a very low perceived default risk.

But, every bond issued, including bonds issued by a municipality or a government agency, will have its own credit rating.

Bonds are generally thought to be safe investments that have a rate of return that is guaranteed.

Professional financial advisors will typically recommend that their clients keep part of their investments in bonds and that they increase this amount as they get closer to retirement.

Level of Risk

Although a debenture is unsecured, it isn’t always riskier than other bonds.

In fact, U.S. Treasury bills and U.S. Treasury bonds are actually debentures; neither of these is secured by any collateral.

Yet, U.S. Treasury bills and U.S. Treasury bonds are both considered to be free of any risk.

Likewise, corporations frequently use debentures as a type of long-term debt instrument.

Companies use these bonds as a way to raise money for expansions or other projects.

The companies then expect to pay the money back from earnings.

These types of bonds are creditworthy if the company issuing the debentures is creditworthy.

Both debentures and bonds are ways for the government or companies to finance projects that require capital beyond what they receive from their average cash flows.

Final Thoughts

Debentures and bonds both provide a way for businesses to obtain capital at a fixed interest rate.

These methods of obtaining capital also have less impact on a business than selling more shares in the business.

Although, there are some cases in which debentures or bonds may be converted into equity.

This depends on the situation as well as the business involved.

Debt interests are one of the most popular methods for companies to obtain capital in today’s business world.

Key Takeaways

• A debenture is a type of bond which is unsecured.
• Debentures are the most common type of bonds used by companies and governmental entities.
• Debentures are commonly used by companies with significant assets and healthy revenue as a way to avoid tying up assets.
• A common example of debentures includes United States Treasury bonds which do not offer collateral as security.