Last Updated on May 24, 2022 by Aradhana Gotur
When we talk about companies raising funds, the most popular method is to issue shares. Investors buy the shares and become shareholders of the company. That makes them part-owners in the company. Debentures are another way through which companies raise money, but here, the investors are only creditors to the company. Debentures are long-term debt instruments that companies issue for which investors are paid back with regular interest.
Some debentures can be converted into ordinary shares while the reverse is not possible. In this write-up, we will discuss the major difference between shares and debentures.
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How do shares work?
Shares are the most common financing option to raise fresh funds. By purchasing shares, you become a part-owner in the company, equivalent to your shareholding. Some shares also give you voting rights, and you also enjoy a part of the company’s profits in the form of a dividend.
How do debentures work?
Debentures are a tool to raise debt, and companies use this debt to invest in the business and earn profits. They are basically a contract drawn up between an investor and the company, where the company gets funds for business and the investor or lender is assured a sum over the assets of the company.
Unlike shares, debentures are borrowed funds where the debenture holder becomes a creditor for the company. Debenture holders do not get ownership in the company, therefore, they do not get any voting rights as well.
However, the companies pay debenture holders a certain rate of interest. The rate of interest is pre-decided and the default risk is with the investor. Therefore, you need to research well before lending your money. There are credit rating agencies that help check the credibility of a borrowing company and release reports that investors may access before deciding to buy debentures.
Just like shares, there are a few types of debentures that vary based on their functionality and redeemability. Let’s take a quick look.
Types of debentures
Secured debentures and unsecured debentures
In case of insolvency or bankruptcy, the secured debenture holders will be the first ones to receive their principal amounts from the asset sale. In this case, the debenture holders do not have rights over any assets.
Redeemable debentures and non-redeemable debentures
Under redeemable debentures, the investors can redeem the principal amount within a set time frame. Whereas, non-redeemable debenture holders only earn interest on the capital for the rest of their life. The capital is paid back only after liquidation.
Convertible and non-convertible debentures
Convertible debentures are debt instruments that can be converted into ordinary shares within pre-decided time by the company. On the other hand, non-convertible debentures do not have this feature.
Who can invest in shares and debentures?
As we know, the stock market is very volatile. While equity shares have a high potential for profits, they are considered a risky financial instrument. Thus, investors need to have an appropriate high-risk appetite to invest in stocks. Also, equity shares do not guarantee any fixed income. Should investors be looking for fixed income, then debentures may be a better financial instrument that one may consider adding to the portfolio.
Investors who have a low risk-taking capacity may also explore investing their capital in debentures issued by quality companies. Investors earn a fixed return on their capital as debentures offer interest on the units.
How to invest in shares and debentures?
To invest in shares and debentures, you would need to enlist the services of a good broker who can keep your financial holdings safe and secure. It is mandatory to have a Demat and trading account to invest in shares and debentures. Note that both these instruments are traded in the primary and secondary markets.
Major differences between shares and debentures
|Basis Of Comparison||Shares||Debentures|
|Meaning||Shares are part of the capital of the company and issuing shares helps increase market capitalization.||Debentures are borrowings and the company adds debt to the books.|
|Nature Of Ownership/Capital||Investors get ownership in the company when they buy shares. Shares are issued from the capital of the company.||It is borrowed funds for the company. Investors become creditors or lenders who loan the money to the company.|
|Role In The Company||Shareholders own a part of the company.||Debenture holders are just debtors for a company.|
|Types||Equity shares are of two types: Ordinary and preferential shares.||Debentures are categorized into: Secured and unsecured debentures, convertible and non-convertible debentures, and registered and bearer debentures.|
|Returns||When a company earns profit, it distributes dividends to the shareholder. Those dividends are the source of income.||Debenture offers interest rates on their units. Therefore, debenture holders enjoy fixed interest payments.|
|In case of solvency||While preferential shareholders have the right to receive funds in case of solvency, common shareholders are not prioritized.||They act as creditors to the company. Therefore, they are given first preference in case of asset liquidation.|
|Convertible||You can not convert shares into debentures.||Convertible debentures are a type that can be converted into shares within a set time frame.|
|Voting rights||Shareholders get voting rights in the company.||Debenture holders do not hold any voting rights in the company.|
Shares and debentures, though are ways for a company to raise funds, are two very diverse financial instruments. Their inherent characteristics of equity and debt, respectively, make it easier for the investors to choose between them.
Generally, debt instruments subdue the risk exposure from equity. Therefore, if investors have a heavy risk appetite, then they may consider equity shares, whereas, if they do not want to put their capital at risk, they could explore earning fixed interest from debentures. A mix of both in the portfolio may provide good diversification and a balance of risk-reward. Speak with your financial advisor before investing.
Research before you start investing. If you are still waiting for the right time to invest, start investing this Diwali. In India, Muhurat Trading is considered to be an auspicious time to start investing. But make sure not to invest blindly, research and screen the stocks on Tickertape.