Bonds vs Debentures: Differences and Similarities

Bonds and debentures are debt or fixed-income instruments that are similar yet different.

For starters, both the debt instruments offer you safe investment options for your money. At the same time, they allow governments and companies to raise funds for their operations.

Not sure how? 

Then you need to understand bonds and debentures and how they work before learning about the differences between the two.

Understanding bonds

A bonds is a fixed-income instrument that represents a loan given by the bond's buyer (investor) to the bond's issuer (borrower).

Generally speaking, bonds are backed by a collateral/asset that the investors have a right over if the issuer fails to repay the debt. Such bonds are called secured bonds.

If a bond is not backed by a collateral/asset, it is called an unsecured bond.

How do bonds work?

A buyer or investor of the bond will receive regular interest payments as long as he holds the bond or until the bond matures. At maturity, the bondholder will receive his initial investment or principal back.

Exceptions to this are zero coupon bonds which do not pay any interest but pay out all the profits at bond maturity.

Who issues Bonds and Why?

Bonds are issued by two types of borrowers: companies and governments.

Bonds issued by companies (private or public sector) are called corporate bonds. Long-term bonds issued by governments are called G-Secs (issued by the central government) and State Development Loans or SDLs (issued by the state governments).

Companies and governments issue bonds to raise money that can finance their projects. For example, the Government issues bonds to finance infrastructure projects (highways, railways etc.) or welfare schemes. Corporations may issue bonds to finance a new project or factory or strengthen their financial position.

Who invests in Bonds?

Retail investors, HNIs, foreign investors, and institutional investors (like pension funds and mutual funds) invest in bonds. 

In fact, the global bond market is way bigger than the global stock market.

Understanding Debentures

Like bonds, debentures are fixed-income instruments too.

The terms ‘bonds’ and ‘debentures’ are used interchangeably. Both represent the debt obligations of the entity that issues them.

Bonds and debentures have different meanings in different countries. US and UK lead the way for usage of the terms as follows:

The extent to which the terms ‘bonds’ and ‘debentures’ are used interchangeably in India makes it difficult to define them precisely. We have attempted to define both below loosely:

Debentures are debt instruments issued by private and public sector companies (PSUs) for short-term financing.

Bonds are debt instruments issued by governments, banks and public sector companies for short-term and long-term financing.

Note: Because ‘bonds’ and ‘debentures’ are practically the same in India, many exceptions exist to the above definitions.

Similarities between Bonds and Debentures

Bonds and debentures are both debt instruments that represent a loan made by an investor to a borrower. They are both used by organizations to raise money, and they both offer investors a fixed income stream. Here are some of the key similarities between bonds and debentures:

Security

Security refers to an asset or group of assets put up by the bond issuer as collateral. Bondholders can go after the asset(s) in case of default by the bond issuer.

Think of it in terms of a home loan which is like an agreement between a home loan borrower and their bank. If the borrower fails to repay the loan, the bank can go after the house, which acts as collateral or security for the home loan.

Both debentures and bonds could be either secured or unsecured.

However, Government Bonds (state and central) are always unsecured. Despite being unsecured, government bonds are said to have a sovereign guarantee and are least likely to default. Government bonds are also sometimes referred to as ‘risk-free bonds.’

PSU bonds and debentures are less likely to be secured than those issued by private sector companies. This is due to the implicit government guarantee on PSU bonds.

Regular interest payments

Both bonds and debentures are interest-paying instruments (with a few exceptions, like zero coupon bonds).

The interest payments could be monthly, quarterly, semi-annually or annually.

Government bonds pay interest twice a year or semi-annually.

Private sector debentures, on the other hand, generally pay interest annually. Many debentures pay interest at monthly, quarterly and semi-annual frequencies too.

Risk

Bonds and debentures are subject to similar risks. Here are a few:

1. Credit Default Risk: Credit default risk is the risk that the issuer will not be able to pay the interest/principal of the bondholders. Credit default risk is quantified by the credit rating of the bond that independent credit rating agencies award. The government has the overall highest credit rating of ‘Sovereign.’ The credit ratings of corporations range from AAA (highest) to D (default).
2. Interest Rate Risk: Interest rate risk is the risk that the interest rate in the market will fluctuate after you have purchased the bond. Interest rate fluctuations result in bond price fluctuations. Interest rate risk is high for long-term bonds. It is relatively low for short-tenure or short-term bonds.
3. Reinvestment Risk: This is the risk that the coupons or interest received will have to be reinvested at a lower interest rate. This can happen if interest rates in the market fall after you have made your initial investment.
4. Liquidity Risk: Liquidity risk is the risk that you may not be able to sell your bonds at a fair price or at all. This generally happens when the bond is not traded enough or at all.

Taxation

Both bonds and debentures are treated identically from the taxation point of view.

We will not go into the finer taxation details of bonds and debentures here as that is not relevant to the discussion.

Tax-Free Bonds and MLDs (Market Linked Debentures) are notable exceptions with unique tax treatments.

Bonds vs Debentures: The differences

Issuer

The primary difference between bonds and debentures is who issues them.

Bonds are generally issued by governments (central and state), banks and PSUs (public sector companies).

Example: 4.26% GS 2023 was issued by the Government of India on 17th May 2021. It’s a 2 year (short-term) bond with a coupon rate of 4.26%. The bond will mature on 17th May 2023.

On the other hand, debentures are generally issued only by private sector companies and PSUs (public sector companies).

NCD is the most common type of debenture issued.

Example: IIFL Finance Ltd 8.65% is a senior secured NCD (non-convertible debenture) issued by IIFL Finance Ltd, a private NBFC. It matures on 24th Jan 2028.

Tenure

Tenure of a fixed income instrument indicates the length of period the issuer will use the money. If an issuer issues a bond in Jan 2020 that will mature in Jan 2025, the bond has a tenure of 5 years.

A bond matures when the issuer returns the money it has raised from the bond and stops paying interest. Simply put, the bond is extinguished on maturity.

Bonds and debentures have tenures that range from a few days to many years.

However, bonds are generally long-term instruments, while debentures usually are short-term instruments.

The tenure of bonds ranges from a few days to 40 years (for government bonds) and perpetuity or forever (perpetual bonds like Additional Tier 1 Bonds issued by banks).

On the other hand, the tenure of debentures ranges from 90 days to 20 years. There are no perpetual debentures.

Safety

Generally, bonds are considered safer than debentures because issuers of bonds (governments, PSUs, banks) are strong institutions.

Safety associated with governments and PSUs is pretty obvious. Banks are strong financial institutions because of how tightly they are regulated by the RBI (Reserve Bank of India) and rarely in the danger of not fulfilling their debt obligations.

Debentures are slightly riskier than bonds because they are issued mostly by private sector companies. Private sector companies must generate revenues and profits to service their debt obligations. Despite strong business models, private sector companies are subject to macro factors and events (like a recession) that are beyond their control and affect their profit-making ability adversely.

Interest rates

While interest rates offered by issuers depend on multiple factors, generally speaking, debentures offer higher interest rates than bonds. This is a critical difference between bonds and debentures since interest rates determine the cash flows you will receive.

Suppose a private company issues a debenture at the same interest rate as a state government bond. In that case, no rational investor will prefer the debenture over the bond. Investors need to be compensated for the extra risk they take by being offered higher interest rates.

The higher interest rates debentures offer to attract investors to invest in them.

Convertibility into shares

Another difference between bonds and debentures is that while debentures can be converted into shares of the issuer, bonds cannot be converted.

It is important to note that not all debentures can be converted into shares. Also, not all debentures that can be converted into shares can be fully converted into shares.

There are three types of debentures from the convertibility factor:

1. Non-convertible
2. Partially convertible
3. Fully convertible

The debentures convert into shares at some predefined condition or time. An example of a predefined condition could be that debentures convert into shares when the share price exceeds a specific value.

Both the issuers and investors of convertible debentures have certain advantages.

Issuers have primarily two advantages. First, they can issue convertible debentures at lower interest rates because the convertibility has some value. Second, they can postpone equity dilution and dilute equity under comfortable conditions.

Investors have an advantage because they can buy a promising company's shares in the future (when the debentures convert into shares). Until the debentures convert, they enjoy a cash inflow through coupons/interest payments.

Importantly, most debentures issued by private companies in India are non-convertible, also known as NCDs (non-convertible debentures).

Differences between bonds and debentures in tabular form

Conclusion

Bonds and debentures are fixed-income instruments. The line dividing the two is finer in India than most other parts of the world, giving rise to many exceptions if we try to define them precisely.

However, loosely speaking, bonds and debentures do have some differences in aspects such as issuer, tenure, safety, interest rates and convertibility into shares.