Debentures vs Traditional Bonds: What You Need To Know

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When delving into the world of investments, you’ll encounter a variety of options, each with its own set of characteristics and benefits. 

Among these are debentures and traditional bonds, two common types of fixed-income securities that often confuse investors due to their similarities. However, there are key differences that set them apart. Keep reading to learn more.

See: 3 Things You Must Do When Your Savings Reach $50,000

What Are Debentures?

Debentures are a type of long-term financial instrument used by large companies to borrow money at a fixed rate of interest. Unlike traditional bonds, debentures are not secured by physical assets or collateral. 

Instead, they are backed by the general creditworthiness and reputation of the issuer. This makes them a riskier investment compared to secured bonds.

Types of Debentures

Debentures come in various forms, including: 

  • Convertible debentures, which can be converted into equity shares of the issuing company after a specific period
  • Non-convertible debentures, which cannot be converted into equity but generally offer higher interest rates

How Do Debentures Work?

When you invest in a debenture, you are essentially lending money to a company in exchange for a fixed interest rate. The company agrees to pay interest at regular intervals and to return the principal amount on a specified maturity date. The interest rate on debentures typically reflects the credit rating of the issuer and prevailing market conditions.

What Are Traditional Bonds?

Traditional bonds are debt securities where the issuer, such as a corporation or government, borrows funds for a defined period at a fixed interest rate. 

Unlike debentures, most traditional bonds are secured, meaning they are backed by specific assets or collateral. If the issuer defaults, bondholders have a claim on the assets.

How Traditional Bonds Work

Investing in traditional bonds means you are lending money to the bond issuer. In return, you receive periodic interest payments based on the bond’s coupon rate. Upon maturity, the issuer repays the principal amount. The security of collateral makes traditional bonds a lower-risk investment compared to debentures.

Debentures vs Traditional Bonds: Key Differences

Understanding the key differences between debentures and traditional bonds is crucial for informed investment decisions. While both are methods of raising capital, they differ mainly in terms of security and risk. Here are some differences to know:

  • Security: Debentures are unsecured and rely on the issuer’s creditworthiness, while traditional bonds are usually secured by collateral.
  • Returned in interest: Due to the lack of collateral, debentures generally offer higher interest rates to compensate for the increased risk. In contrast, traditional bonds have lower risk and, consequently, may offer lower returns. The interest schedule for each depends on the term.
  • Conversion options: Some debentures offer the option to convert into equity, which is not a feature commonly found in traditional bonds.
  • Issuer: Corporations typically issue debentures, whereas governments and corporations issue traditional bonds.
  • Purpose: Although both can help a company raise money, debentures are usually sold to fund something specific.

Fixed vs. Floating 

Bonds and debentures can both be fixed or floating, but the term means something a little different for each of them

Fixed vs. Floating Bonds

For bonds, fixed and floating describes the interest rate. Fixed bonds have set interest rates that don’t change for the entire term, while floating bonds might pay different interest based on what’s happening in the market.

Fixed vs. Floating Debentures

Although some debentures aren’t secured to any collateral, they can be. For debentures, fixed and floating describe the collateral it is secured to. Fixed debentures are secured to a single asset, like a building. Floating debentures are secured to something that has more flexibility, like a company’s stock.

How Are Bonds and Debentures Taxed?

Bonds are taxed based on the type. You’ll have to pay federal taxes on the interest you earn from corporate and U.S. Treasury bonds. However, you won’t have to pay federal taxes on the interest for a municipal bond. If you sell the bond, you would have to pay capital gains taxes on any profits.

Final Take

Both debentures and traditional bonds can be integral parts of a diversified investment portfolio, but it’s crucial to understand their differences. Debentures might be more suitable for investors willing to take on more risk for higher returns, while traditional bonds appeal to those seeking a safer investment. As with any financial decision, consider your investment goals, risk tolerance and the specifics of the individual security before investing.

FAQ

  • What’s the main difference between debentures and bonds?
    • The key difference is that debentures don’t have to be secured to any assets, but a bond does. 
  • Are debentures riskier than bonds?
    • Debentures can be risker than bonds because they aren’t secured to anything other than the company’s reputation. 
  • Can I invest in both debentures and bonds?
    • Yes. You should keep your portfolio diverse and invest in many different types of assets. 
  • How are interest rates set for debentures and bonds?
    • The interest rate depends on the market at the time that the debenture or bond is sold.

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