Debenture and bond are used often as interchangeable terms. Bond is used as a broader term which may include the debentures. Let’s categorize bonds into two – ‘with security’ and ‘without security’. The bonds without security can be technically called debentures. Therefore, debentures are like subset of bonds.
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A Source of Debt Finance
Debenture holders are paid periodical interest on their loan and the principal is paid back at the completion of the entire term. Bondholders, on the other hand, are normally not paid any periodical payments. They receive the accrued interest and the principal upon the term completion at one go. In the new market innovations, this is not a strict feature of bonds and can be customized to regular or periodic payment.
Both the types of instruments are issued by corporations as well as governments.
Difference between Debenture vs. Bond
Debenture and bond are used often as interchangeable terms. However, there are subtle and noteworthy differences between the two instruments:
A bond is a more secure instrument than a debenture. A debenture does not have any collateral backing; whereas a bond will always have collateral attached to it.
For an example in layman’s terms, if an issuing company fails to pay interest or the principal to the bondholders, the amount can be realised by selling the collateral i.e. the asset that is kept as a security. Whereas in case of debentures, selling any asset and realising money is not an option. This is because it is not backed by any security. Against the security, the debenture holders only relied upon the credibility of the company while investing money and the credibility is not saleable in open market.
It should be noted that these terms are quite loose terms because there are concepts of secured debentures where the debentures are also secured by asset. It all depends on how the instrument agreement is structured.
Rate of Interest
Debenture holders are entitled to a higher rate of interest in comparison to bond holders. The reason is that debenture is an unsecured loan and therefore, is riskier than a bond. There is a direct relation between risk and return. In simplest terms, risk can be defined as level of assurance of cash flow. Higher the risk, higher is the expected return and vice versa. On that very principle, debenture are perceived high risk bearing instruments compared to bonds as we already observed that bonds are secured whereas debentures are not.
In a case of a liquidation / bankruptcy, the company is liable to pay bondholders on priority, whereas debenture holders are paid later.
Bankruptcy is a very unfortunate event and it normally happens when a corporation is not having sufficient funds or assets to pay off its liabilities. Once bankruptcy is filed, the official liquidator sells the assets of the company and honors the liabilities as far as possible. In our case, since, bonds are secured by an asset, the money realized from this asset would be given to bond holders. On the other hand, debenture holders will get the money left over after paying off other secured liabilities. Note that equity shareholders are the last priority and debenture comes before them.
All the default risk impacts both debenture and bonds. Debentures are completely exposed to default risk whereas bonds have an additional cover in the form of security. So, the risk factor is low in bonds and high in debenture when compared to each other.
Convertibility to Equity
Debentures can be converted into equity if the issue debentures are convertible debentures where is it is not possible with bonds. If we stick to the concept that bonds are secured, they cannot become part of equity while continuing the security. All equity shareholders will have to have same rights.1,2