In The World Of Debt Financial Instruments: Bonds Vs Debentures

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Grip Invest
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Oct 27, 2024
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    Usually, investors use some financial terms interchangeably, such as ‘assets and goods’, ‘bonds and debentures’, ‘financing and accounting’ and ‘broker and dealer’. However, the interpretation and functions of these terms differ. Therefore, understanding them is crucial. 

    Bonds and debentures are debt financial instruments, but they can differ in many ways. Understanding it will potentially help investors in making informed investment decisions.

    Why Is There Confusion?

    Debt instruments are a unique yet lesser-known investment opportunity. Investors are accustomed to investments in equities, PPF, or traditional bank instruments like fixed deposits, recurring deposits, and others. However, the concept of investing money in instruments that can be a ‘liability to other entities’ may be unclear to many investors.

    Moreover, people may also perceive debt financial instruments as a liability, financed by institutions like banks, government and other financial intermediaries only. However, some of these debt financing instruments are available for investment to the common public. These can be in the form of bonds, debentures, commercial papers, treasury bills, and many more. 

    One of the main reasons that can confuse investors between bonds and debentures is their overlapping characteristics. Both these instruments are a debt to the companies or government. And both of them belong to the same category, i.e. fixed-income instruments, which is why some of their features may turn out to be the same.

    However, there are some key differences between bonds and debentures. Let us explore both instruments in detail.

    Understanding The Bonds

    This instrument can be understood as a loan given to the concerned corporation or government. Bonds are also referred to as a certificate that clarifies that the borrower of such loan will pay interest as per the rate of interest mentioned in the agreement. Interest income generation is the key feature of such debt financial instruments.

    The borrowers can finance their operations or specific projects with the money procured through loans. Different factors, like maturity, interest rate, creditworthiness of the borrower, frequency of repayment and collateral, can affect the viability of a bond. 

    In debt instruments, the interest rate is known as the coupon rate for the bonds. Bond price varies as per the market forces. Change in coupon rate leads to the change in the price of a bond. Yield-to-maturity (YTM) is the rate of interest received by the investors if bonds are held up to their maturity. The formula for YTM is as follows:


    Understanding YTM With An Example

    The complex relationship between bond price, YTM and coupon rate can be easily understood with an example.

    Assume an investor purchased a 5-year bond at INR 130 with a coupon rate of 12% per annum, which has INR 100 face value. Now, this instrument has the following yields:

    • Annual yield = 12%*100 = INR 12
    • Current yield = (12*100)/130 =INR 9.231
    • YTM = 0.1324 = 13.24% (calculated as per the above-given formula)

    Investors can observe how a rise in the price of the bond reduces its current yield. It is due to investment behaviour

    When a bond price increases, investors will find old bonds at par value attractive. It will drive their demand. However, a lack of potential demand for new bonds will reduce its yield and vice versa, when bond prices reduce.

    Types Of Bonds

    Bonds can be categorised in various ways based on their issuer and features like coupon rate.

    1. Government Bonds

    These types of bonds are considered reliable as they are backed by the government. Moreover, treasury or government bonds are usually issued by central banks/central/state governments. In India, these are known as G-Sec (Government Securities). Municipal governments also offer bonds and raise money for particular municipalities in charge.

    2. Corporate Bonds

    Bonds issued by public or private companies can be further categorised into secured bonds and unsecured bonds, which differ on the basis of collateral attached to the security.

    3. Other Bonds

    • Zero Coupon Bonds: These are bonds with no interest income. The potential gain only arises when the value of the bond rises at the time of maturity or redemption.
    • Perpetual Bonds: As the name suggests, these bonds do not have any maturity date. They indefinitely pay a fixed interest rate to bondholders. This means that the bond's principal amount is never repaid, and the bond continues to generate interest income for the investor indefinitely.

    Pros And Cons Of Investing In Bonds

    Pros

    Cons

    Usually, these are backed by a collateral and can be comparatively more reliable.

    Credit risk is a crucial feature of debt instruments.

    Some bonds offer taxation benefits for the investors.

    A rise in interest rates may make old bonds unattractive for investors, reducing their present value.

    Debentures: A Brief Overview

    Debentures are a form of loan instruments, usually for medium to long term, which are offered by both large companies and the government. They primarily work on the reputation of the issuing authorities and at a fixed interest rate. The interest rate offered is known as a coupon and has an inverse relationship with the debenture price. They are peculiar to their interest payment. Given the wide variety of debentures available and the presence of unsecured nature in some types of debentures, the creditworthiness of an issuing entity becomes crucial when considering investment in them. 

    Understanding Debentures With An Example

    Debentures work like bonds in some ways but the unsecured nature of most debentures makes them different from bonds. 

    Assume a debenture’s face value is INR 1,000, the interest rate is 5% per annum, and the term is 10 years. So, this debenture pays a fixed interest of INR 50 annually for a tenure of 10 years. And at maturity, the investor would receive the principal amount of INR 1,000.

    Types Of Debentures

    1. Based On Conversion

    • Convertible Debentures: After fulfilling specific conditions of the issuer, investors can convert them to equity shares partly or fully.
    • Non-Convertible Debentures: These can never be converted to equity.

    2. Based On Redemption

    • Redeemable Debentures: These can be redeemed before maturity.
    • Non-redeemable Debentures: Investors need to wait till maturity for the redemption.

    3. Based On Interest

    • Floating rate Debentures: They adjust their interest payment or coupon rate based on the market forces.
    • Fixed-rate Debentures: They offer fixed interest throughout the life of the debt financial instrument, irrespective of market forces.

    Pros And Cons Of Investing In Debentures

    Pros

    Cons

    Conversion is the key feature of these instruments, offering a mix of equity and debt benefits.

    Default risk is present due to the nature of unsecured instruments.

    The liquidity aspirations of an investor can be met by the debentures, except if it is an irredeemable debenture.

    Conditioned conversion can pose a potential risk when the debt is converted to equity and equity markets are down.

    Difference Between Bonds And Debentures

    Point Of Difference

    Bonds

    Debentures

    Meaning

    These are debt instruments with potential fixed-income features and are usually backed by collateral.

    This debt instrument is not usually backed by any securities but can gain potential interest and get converted to equity.

    Collateral

    Usually, secured bonds are backed by collateral securities.

    Debentures can either be backed by securities or not.

    Conversion

    They have debt features throughout their life and cannot be converted.

    Convertible debentures can be converted partially or fully to equity shares.

    Risk

    Credit risk and interest risk are the main threats.

    Default risk and conversion risk are the main threats.

    Conclusion

    Debt financial instruments can be a potential investment opportunity if they align with the financial goals and risk appetite of an investor. Understanding and analysing them thoroughly can help one diversify their portfolio while ensuring fixed returns. 

    Debt instruments with modern features and secure nature may be a significant addition to your portfolio. Login to Grip and explore the investment opportunities for Securitised Debt Instruments (SDIs).

    Frequently Asked Questions on Bonds and Debentures

    1. What is the main difference between bonds and debentures?The main difference between bonds and debentures is the nature of collateral backing. Secured bonds are backed by collateral, while debentures are mostly not. Moreover, some debentures have a conversion feature, which is absent in bonds. Investors may overlap their meanings, but their features differ significantly.

    2. What are the different types of bonds?

    Bonds are of varied types based on their issuer or features. Government bonds include treasury and municipal bonds, where the government is the borrower. Corporate bonds issued by corporations differ on the basis of collateral backing and are categorised into unsecured and secured bonds. Apart from this, there are zero-coupon bonds and perpetual bonds.

    3. What does a 12% debenture mean?

    Debt instruments are usually accompanied by interest rates. A 12% debenture indicates that the instrument will pay a 12% interest rate. If it has a face value of Rs 1000, then it will pay Rs 120 (1000*12%) as interest.


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    Disclaimer - Investments in debt securities/municipal debt securities/securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully. The investor is requested to take into consideration all the risk factors before the commencement of trading.
    This communication is prepared by Grip Broking Private Limited (bearing SEBI Registration No. INZ000312836 and NSE ID 90319) and/or its affiliate/ group company(ies) (together referred to as “Grip”) and the contents of this disclaimer are applicable to this document and any and all written or oral communication(s) made by Grip or its directors, employees, associates, representatives and agents. This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip does not guarantee or assure any return on investments and accepts no liability for consequences of any actions taken based on the information provided. For more details, please visit www.gripinvest.in

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