Bonds and debentures are both debt instruments used by companies and governments to raise capital, but they have distinct characteristics. Here are five key differences between bonds and debentures:
Security:
Bonds: Bonds can be secured or unsecured. Secured bonds are backed by specific assets of the issuer, which serve as collateral. If the issuer defaults, bondholders have a claim on the specified assets. Unsecured bonds, also known as debentures, are not backed by specific collateral.
Debentures: Debentures are a type of unsecured bond. They do not have specific assets pledged as collateral. Instead, debenture holders rely on the general creditworthiness of the issuer.
Collateral:
Bonds: Secured bonds have collateral, which provides an added layer of security for bondholders. The collateral can be in the form of real estate, equipment, or other assets owned by the issuer.
Debentures: Debentures lack specific collateral. Investors in debentures rely solely on the promise and creditworthiness of the issuer to repay the principal and interest.
Priority in Case of Default:
Bonds: In the case of default, secured bondholders have a higher claim on the specified collateral compared to unsecured bondholders.
Debentures: In the absence of specific collateral, debenture holders are general creditors and may have a lower priority compared to secured bondholders in the event of default.
Risk and Return:
Bonds: Secured bonds, due to the presence of collateral, may carry lower risk for investors. Consequently, they often offer lower interest rates. Unsecured bonds, on the other hand, may offer higher interest rates to compensate for the absence of collateral.
Debentures: Debentures generally carry a higher level of risk for investors compared to secured bonds. As compensation for this risk, debentures often offer higher interest rates.
Use of Proceeds:
Bonds: The proceeds from issuing bonds can be earmarked for specific projects or purposes, especially in the case of project finance. The use of funds is often outlined in the bond agreement.
Debentures: Debentures may not have specific restrictions on the use of funds, providing issuers with greater flexibility in allocating the capital raised.
In summary, while both bonds and debentures represent debt obligations, bonds can be either secured or unsecured, while debentures specifically refer to unsecured bonds. The presence of collateral, priority in case of default, risk-return profile, and use of proceeds are key factors that differentiate these debt instruments. Investors should carefully consider these factors when making investment decisions in the debt market.