Bonds and Debentures
As discussed in our section Investment Type: Overview, a corporation’s debt capital is comprised of bonds, debentures and other forms of hybrid debt securities issued to investors. Bonds and debentures represent the majority of issued debt capital. Although the term bonds and debentures are often used interchangeably the two are distinctly different:
- A bond is typically a loan that is secured by a specific physical asset.
- A debenture is secured only by the issuer’s promise to pay the interest and loan principal.
Bonds can be thought of as similar to a house mortgage. With a house mortgage, as with bonds, if the borrower stops making the regular interest payments, or fails to repay the principal, the lender can sell the house as it is the physical security for the loan.
A bond is like a loan. The issuer of the bond, a corporation or government, is the borrower and the holder or investor, that’s you, is the lender. The borrower promises to pay the investor a preset annual interest rate (known as the bond’s coupon rate) in equal, regular payments for as long as you continue to hold the bond or debenture. The issuer also agrees to repay the bond’s principal, or par value, on a stated maturity date. The annual interest income can be paid in intervals that range from monthly, semi-annual and annual, with semi-annual payments the most common.
Bonds and debentures provide the corporate issuer with external funding to finance long-term capital projects and/or, as in the case of governments, to finance current expenditures. In addition to corporate issuers, governments of all levels also issue debt capital in the form of bonds and debentures. Typically, debt securities issued by governments are not secured by physical assets, thus, they are technically classified as debentures.
Note: Do not assume that bonds secured by physical assets are a safer investment than debentures because this may not necessarily be the case. In fact you should consider a number of criteria before deciding which bond or debenture to purchase. A number of these criteria are discussed in the Bonds and Debentures FAQ section.
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