This article discusses bonds and debentures in detail. One term that almost everyone in the world can relate to is investment. Many people desire to invest their savings based on their purpose and their capacity to manage the underlying risks. There abound various investment options with varying degree of risks and return factor. The risk and gains in an investment is the major factor which influences an investor’s choice of investment in a venture. In many instances, risky investments offer higher returns compared to less risky ones.
Bonds and Debentures are two investment options you should consider as they can offer good returns through interest to the investor. Debentures are convertible or non-convertible debts security issued by a company to the public. Bonds is categorized as a certificate of debt that is issued by a government or company to raise funds. Bonds and debentures are both classified as an instrument of loans obtained from investors but the duration for repayment is where it differs.
WHAT ARE DEBENTURES?
Debt instruments issued by a company to mobilize funds for either short or medium term is referred to as Debentures. In other words, a company will mobilize funds from the public or investors to fulfill their short or medium-term goals by offering debt instruments known as debentures. With this, fixed interest rates are provided to investors periodically as a return on investment.
Debentures can be transferred freely anytime, although getting the offer does not make one a shareholder of the organization. A debenture holder is not entitled to vote nor attend general meetings of the company.
TYPES OF DEBENTURES
The four major types of debentures are:
- Secured Debentures
- Unsecured Debentures
- Convertible Debentures
- Non-convertible Debentures
Secured Debentures: Just as the name implies, these debentures do secure against the fixed company’s asset. In a situation that the company cannot repay the funds contributed by the investor, an asset of the company can be sold to repay the loan.
Unsecured Debentures: In this type, the loans are not secured against the assets of the company. The company may or may not repay the loan to the investor on maturity.
Convertible Debentures: As suggested by the name, this type can either be converted into equity shares or other forms of security by the holder. The terms of conditions of the debentures determine if it will be partly or fully convertible.
Non-Convertible Debentures: These Debentures cannot be converted into shares or securities. Non-Convertible Debentures offers a higher rate of return than Convertible Debentures.
WHAT ARE BONDS?
Bonds are debt instruments issued by government bodies and companies to raise fund from investors for medium to long-term needs. Bonds allows companies or the government to mobilize funds for long-term projects. It is a secured investment and offers medium or low-interest rates. In an event that the company collapses, bondholders are the first to be considered for compensations.
However, investing in company bonds does not make you a shareholder neither can you partake in voting or general meetings of the company.
TYPES OF BONDS
Mutual fund bonds can be categorized as actively managed bond, passively or indexed managed bond, open-end and closed end, sponsored of open-end bond funds, unit investment trust, etc.
- Actively managed bonds: As the name suggests, actively manage funds are managed by the fund managers who trade the funds in accordance with the aim of the investment. These managers can opt to sell the funds for profit, or create capital gains or loss to raise cash for shareholders who may want to part with their bonds.
- Passively or indexed managed funds: these bonds are not actively managed but are created to match the features of certain bonds. The change in the index is direct with the portfolio.
- Open-end bond: Mutual fund companies oversee these bonds. The responsibility is to make new offers in bonds which would redeem existing ones which requires the managers to invest new funds that come in and liquidate positions to when cash is needed for redemptions. Investors can reinvest in new fund shares automatically after receiving their capital gains and interest income.
- Closed-end bonds: This bond is limited in the number of shares it can trade in the market. It is like stocks with a price that is adjusted based on the supply and demand in the market. This bond can be index or actively managed.
- Exchange traded funds: exchange-traded funds are like baskets of bonds with a non-fixed number of shares but can reflect an index. These bonds trade on the exchange through brokers who charge commissions by trading on them.
- Unit Investment Trusts: these are a portfolio of bonds in a trust that has a limited number of shares to sell. When the bond is mature, the portfolio will be closed and the gains realized will be disbursed to the investors based on the proportion of their investment. This type of investment is mostly initiated by brokerage companies that keep a secondary market for the individual units. Holders who may wish to sell off their shares before the maturity date is bound to receive an amount which much less than their initial investment.
DIFFERENCES BETWEEN BONDS AND DEBENTURES
The table below highlights the differences between bonds and debentures.
|1||They are financial instruments issued by government agencies to raise funds.||They are financial instruments issued by companies and organizations.|
|2||They are often secured by assets.||They may or may not be secured by assets.|
|3||Interest rate is low.||Debentures have a higher interest rate.|
|4||Investors in bonds are called bondholders.||Investors in debentures are called debenture holders.|
|5||Only accumulated interest can be paid on bonds.||Interests are paid periodically irrespective of the situation of the company in terms of profits.|
|6||It has a lower risk factor.||The risk factor is high.|
|7||At the time of liquidation, bondholders are given priority for payment.||Debenture holders are not given priority on payment during liquidation of assets.|
|8||Debt instruments are long-term.||These are short-term debt instruments.|
|9||They cannot be converted into equity shares.||They can be converted into equity shares.|
|10||Bonds have many types.||The types of debentures are limited to two or three in all.|
|11||They may or may not be traded in exchanges.||Debentures are traded in exchanges.|
|12||Interest on bonds are fixed until maturity.||Interest on debentures may vary with time until maturity.|
HOW TO INVEST IN BONDS?
Investment in bonds can be made by purchasing an individual bond, bond funds, and money market funds.
Individual Bonds: this type offers you the option of choosing from a variety of bonds. It is important that you check for a bond that matches with your needs and interest before investing. Many of these individual bonds are traded in over-the-counter market. This market is made up of firms that buy or sell securities online.
Bond Funds: this is another way of investing in bond markets. They are more like stocks, with securities that are professionally selected and managed. They offer a number of advantages by allowing investors to diversify risks across various issues.
Money Market Funds: Money market funds are investments in short-term with high liquid securities. These securities are in the form of treasury bills, certificates, municipal bonds and commercial papers issued by authorized corporations. In many cases, these funds contain instruments and securities that mature in three months or thereabout. Investors in money market funds can withdraw their funds anytime.
THINGS TO CONSIDER BEFORE INVESTING IN BONDS
When investing in bonds, you are purchasing a debt from the issuer which can be government or an affiliate of the government. The major features of bonds include:
- A maturity date on which the interest will be paid to the bondholder.
- A promise of paying a tax-exempt interest at a given coupon rate.
- The coupon rate determines the return on investment.
- Credit rating which is tagged with the bond provides a clue on the possibilities that it could be repaid.
POSSIBLE RISKS ASSOCIATED WITH INVESTMENT IN BONDS AND DEBENTURES
Bonds and debentures have the tendency to offer stable returns and safer investment than stocks. However, they are not without the following risks:
- Interest risks
- Liquidity risks
- Credit risks and
- Reinvestment or call risk
Interest Risk: bond prices fall whenever the interest rates in the market rise. On having to sell out your bond before its maturity date, you are likely to get less than what you invested. The interest rate falls in value as the maturity date becomes near.
Liquidity risk: on the condition that the interest rate is higher than the coupon rate, an investor that intends to sell his bonds before the maturity date may have difficulties seeing a buyer. At the initial stage of issuing the bond, the trading volume is larger and is more liquid.
Credit risk: if the issuer is declared bankrupt or gets into a financial hiccup, it may fail to pay the bondholders and there is the likelihood that investors may not get anything.
Investment risk or Call risk: any bond that can be called could be redeemed by the issuer before the actual maturity date. When interest rates fall, bonds can be called, which offers the investor the choice of reinvesting the income at a lower rate.
SHOULD YOU INVEST IN BONDS OR DEBENTURES?
From the comparisons made in this article, the choice lies with you. Generally, the two investment option offers interest rates; except in cases where debentures are converted to equity shares. It necessary to look for both the period of repayment and the expected returns on investment.
As a hint, investing in quarterly payments will attract higher yields annual payments comes with a lower yield. Cumulative schemes are available for both bonds and debentures which pays the whole sum on maturity.
Governments and companies can gain funds for projects and investments beyond their normal income by issuing bonds and debentures. Both of them are forms of borrowed capital. However, bonds are more secure than debentures. In both cases, it is necessary for you to examine the creditworthiness of the issuer before investing.
Bonds and debentures are not without risks; but in each case, they are an investment option worth considering. It is a risk worth taking because of the security and the interest rate that comes with the investment.