A debt security is a financial instrument that helps in acquiring capital through borrowing money from the investor or the general public by the government, companies, or financial institutions. In exchange, the borrower agrees to pay an interest rate, determined to be fixed or variable, and repay the amount on a stipulated date. It can be considered an example of a creditor and borrower relationship because the holder does not have ownership rights to the instrument. A debt instrument plays a vital role in the Indian economy as it provides sound opportunities and helps in capital formation. Examples include government securities, bonds, debentures, treasury instruments, and commercial papers.
What is a Bond?
A bond is a financial instrument that shows a loan given by investors to other entities, such as the government, public agencies, or firms. For instance, if an individual chooses to purchase a bond, it shows that he or she has borrowed cash from the issuer of the bond. As a result, an agreement is reached for the issuer to repay the cash, along with some interest, after an agreed-upon maturity period.
Concept:
- Interdisciplinary nature
- Bonds are instruments of long-term financing in which fixed returns in the form of interest are provided.
- The issuer, in this case the borrower, becomes aware of the liability to repay the amount borrowed.
- Bonds are regarded as instruments of debt.
- They are not ownership instruments.
Parties involved:
- Issuer – The party that issues the bond, also known as the borrower. This can be either the government, a public institution, or a company.
- Investor or Bondholder – the party that lends money
- Intermediaries – The middlemen consist of stock exchanges, banks, and other financial institutions. These middlemen help in the facilitation of the buying and selling of bonds.
Key Features of a Bond:
- Face Value: This is the final amount to be repaid at maturity.
- Coupon Rate is the rate at which interest is paid.
- Maturity Period refers to the duration after which the principal is returned.
- Bonds are offered at their initial price.
- Redemption Value: The amount disbursed at maturity, typically equivalent to the face value.
Types of Bonds:
- Government Bonds: Issued by national or state authorities.
- Corporate bonds are issued by companies to generate capital.
- Municipal bonds are issued by local governments.
- Zero-Coupon Bonds are sold at a discount without periodic interest payments.
- Tax-free bonds exempt the interest income from taxation.
- Floating-rate bonds feature fluctuating interest rates based on market conditions.
Objectives of Issuing Bonds:
- To finance infrastructure and development initiatives.
- To satisfy long-term capital needs.
- To lessen reliance on equity financing.
- To support public welfare and economic development efforts.
Advantages of Bonds:
- Offer stable and predictable income.
- Present lower risk in comparison to stocks.
- Appropriate for conservative investors.
- Can be traded in secondary markets.
- Some bonds offer tax benefits
What is a Debenture?
Debentures are instruments of long-term finance. They are used by the company to raise funds from the general public or financiers. It can be explained in this way: It is regarded as an agreement to pay off the principal amount at a stipulated future time, along with payment of interest at regular intervals.
When an individual makes an investment in the debenture, he or she becomes a creditor of the business and not its member or shareholder. This implies that the individuals who hold debentures do not possess any voting rights within the company.
Meaning and Nature:
- The term debenture can also be defined as finance or loan capital pursuant to the Companies Act of 2013.
- A fixed interest rate, with regular payments being disbursed.
- It involves payment of the principal amount at the end of the term.
Key Features of Debentures:
- Acknowledgement of Debt: The company acknowledges its liability to repay the borrowed sum.
- Fixed Interest: It pays regardless of the fact that the company makes profits or not.
- Medium to long-term maturity periods are preferred for the issuance of debentures.
- Transferability for freely listed debentures is possible.
- It does not provide ownership, and debenture holders are known as creditors, not shareholders.
Types of Debentures:
- Secured Debentures are backed by a claim on the company’s assets.
- Naked or unsecured debentures are not backed by any security.
- Convertible Debentures may be converted into equity shares after a certain period.
- NCDs cannot be changed into shares.
- Redeemable Debentures have to be repaid after a specific time.
- Irredeemable (Perpetual) Debentures can only be redeemed in the case of liquidation.
Rights of Debenture Holders:
- Debenture holders have the right to get interest on time and the return of principal on maturity.
- They can sue upon default.
- They are entitled to claim corporate assets that are secured.
Advantages of Debentures:
- It is a way to raise funds without giving away the ownership of the company.
- They offer the investors a very dependable income stream.
- They offer higher returns than government bonds.
- They suit investors looking to generate stable returns.
Bond Vs Debenture
The words “Bond” and “Debenture” are often considered synonyms when used in general conversation, but they are definitely not synonymous with each other. They can be considered instruments of debt for fundraising purposes, but they differ in several ways when it comes to their characteristics or features.
| Basis of Comparison | Bonds | Debentures |
|---|---|---|
| Meaning | A bond is a long-term debt instrument issued by governments, government bodies, or large financial institutions to raise funds from the capital market. It provides fixed interest income and repayment of principal on maturity. | A debenture is a written acknowledgement of debt issued mainly by companies, under their common seal, promising repayment of principal along with interest. |
| Issuing Authority | Issued by Central and State Governments, Municipal Corporations, Public Sector Undertakings (PSUs), and Financial Institutions. | Issued exclusively by companies registered under company law, including private companies and public limited companies. |
| Security | Generally secured instruments backed by government guarantees or specific assets. | Can be secured (backed by company assets) or unsecured (also called naked debentures). |
| Risk Level | Considered low-risk investments. Government bonds are often viewed as risk-free and suitable for conservative investors. | Higher risk compared to bonds, depending on the company’s financial stability and the type of security offered. |
| Interest Rate | Offer relatively lower interest rates due to lower risk exposure. | Provide higher interest rates as compensation for higher risk. |
| Repayment Priority | Government bonds have a high certainty of repayment due to sovereign backing. | Debenture holders are treated as creditors and are repaid before shareholders during liquidation. |
| Convertibility | Generally non-convertible; conversion options are rare. | May be fully convertible, partly convertible, or non-convertible. |
| Ownership Status | Bondholders are creditors, not owners, and have no role in management. | Debenture holders are also creditors with no ownership rights or voting power. |
| Tenure | Usually long-term, often ranging from 10 to 40 years. | Can be short-term, medium-term, or long-term. |
| Tradability | Actively traded on bond and stock exchanges, offering high liquidity, especially in developed markets. | May be listed or unlisted; liquidity depends on the company’s reputation and market demand. |
| Legal Documentation | Governed by RBI/SEBI regulations, government notifications, and bond indenture agreements. | Governed by the Companies Act, 2013 and debenture trust deeds. |
| Utilisation of Funds | Used for infrastructure development, public welfare projects, government expenditure, and long-term capital needs. | Used for business expansion, working capital, machinery purchase, and corporate restructuring. |
| Credit Rating | Usually carry high credit ratings; government bonds may not require ratings. | Mandatory credit rating to assess the company’s repayment capability. |
| Tax Treatment | Interest may be taxable or tax-exempt in the case of certain government bonds. | Interest income is fully taxable for investors. |
| Examples | Government of India Bonds, RBI Savings Bonds, Municipal Bonds, PSU Bonds (NTPC, PFC, REC). | Company fixed-rate debentures, Non-Convertible Debentures (NCDs), and Convertible debentures issued by private firms. |
Both bonds and debentures are debt instruments, but they differ significantly in issuer, security, risk, and return. Bonds are generally safer and more stable, making them suitable for risk-averse investors, while debentures offer higher returns with higher risk, making them appropriate for investors willing to take moderate risk for better income.
Conclusion
Bonds and debentures are a vital component of the financial system and serve as a primary source of long-term funding for business corporations as well as the government. For investors, both tools show a creditor and debtor interaction and might produce fixed or variable profits.
Both instruments help with the mobilisation of savings, infrastructure development, and capital creation, even if they have many differences. In portfolios, they also offer stability, a regular flow of income, and diversification advantages.
Understanding bonds and debentures can greatly assist investors in making wise financial choices, hence advancing the general efficiency and expansion of the economy.
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