Differences Between Shares and Debentures
One of the common attributes of successful investors and traders is that they hold diversified portfolios. As the saying goes, “never put all your eggs in one basket”. Similarly, reliance on a single financial product or the same asset exposes your corpus to a high degree of risk. To hedge your risks, experts recommend having a balanced and diverse portfolio that contains a healthy mix of equity and debt instruments.
Company stock is the most popular form of equity. Debentures, on the other hand, are a form of debt-based tool. As you read on, you will learn about the salient features and the differences between shares and debentures, and it will help you determine the investment option that is apt for your needs.
What are Shares?
When you buy a share of a company, you get a partial ownership of the company that is proportionate to your investment. There are two types of shares: equity shares and preferred shares. Equity shares make you eligible for any dividends that the company may declare. Preferred shares give you additional privileges and selective voting rights.
Shares or stocks of a public-listed company can be easily bought in the share market – using a valid trading and demat account – directly from other shareholders who are willing to sell. Sometimes, the company itself releases shares to the public to raise capital for growth and expansion activities, or debt consolidation.
What are Debentures?
Debentures are a debt-based investment tool. Not only corporates, but even the government can issue debentures, which are, basically, unsecured bonds that are issued to borrow directly from willing investors. Unsecured, in this context, means that they do not come with any collateral or security backing them. Due to this aspect, the market reputation and financial health of the issuer are paramount in this case to safeguard your investment.
Another noteworthy aspect of debentures, and common to most debt-bonds, is that they have a longer lock-in term. Usually, it takes 5-7 years or more for debentures to mature and be available for resale or surrendered for receiving the maturity amount.
Shares and Debentures: The Differences
Now that you know the definitions of both these investment instruments, let us take a look at the key factors that are used to further distinguish between shares and debentures. The table provided below serves as a quick and easy-to-refer-to guide for understanding the share and debenture differences.
Criteria | Shares | Debentures |
|---|---|---|
Definition | Shares are company-owned equity and are a form of a capital asset. | Debentures are a form of loan taken out by the company and fall under payable liabilities or debt. |
Risks | Shares are directly impacted by market volatility. Hence, they entail a higher risk for the investor. | Debentures, being a debt-based instrument, have a lower market exposure, and in turn, lower direct risks. However, there is the risk of the issuer becoming bankrupt or unable to abide by the commitment of payment. |
Mitigation | Shares do not have any defined risk mitigation plan as their value largely depends on market conditions and the company’s performance. | Debentures are unsecured loans but the security comes in the form of getting preferred access to the company's assets, in case it files for insolvency. |
Potential Returns | Shares have historically generated a much higher return on investments that are calculated and take into account research-backed risks. | Debentures, usually, come with lower returns that are often fixed for the maturity term. |
Additional Income | Some companies are known to offer dividends (based on their performance) which adds to your income. | Debentures, apart from having a fixed maturity value, often pay a fixed interest amount that is paid out at a predetermined frequency. |
Ownership Status | Shareholders have direct ownership of the company and get voting rights as well. | Debenture holders are creditors and do not have any voting or other rights in the company. |
Liquidity | Shares can be bought and sold freely on the stock market, anytime. | Debentures come with long maturity periods and need to be held for the entire tenure. |
Tax Implication | Proceeds from the sale of shares are subject to capital gains tax. Moreover, any dividends received are taxable as well. | Interest paid on debentures is tax-deductible for the company. There is no capital gains tax applicable in this case, either. |
Conversion | Shares cannot be converted to debentures. | ‘Convertible debentures’ can be converted into shares. |
Trust Deed | Not applicable for shares. | Needs to be executed during the issuance of debentures. |
Shares vs Debentures: What’s right for you?
After having understood the key differences between shares and debentures, you should be in a position to make an informed financial decision. Irrespective of the option you choose, your investments need to be backed by a combination of proper due diligence of the company being invested in, thorough research of market movements and macroeconomic factors affecting the company’s performance, a clear understanding of your own investment objectives, and an honest evaluation of your risk tolerance.
Having said that, shares are highly liquid, i.e., you can sell them whenever the need arises or a lucrative opportunity presents. Also, shares are more suitable for people early on in their earning years as they, generally, have a higher risk tolerance and can use market movements to build a long-term fund. Due to the higher returns offered by shares, it is well suited to meet your mid to long-term financial needs.
Debentures, though, are a more risk-averse investment with a long lock-in period. It may be better suited to people who have a very low-risk appetite or have already built a healthy corpus and are, now, looking for an investment option that can generate a fixed and regular income.
A hybrid model can give you the best of both worlds. By including shares in your portfolio, you can capitalise on market upswings and get a higher return, while introducing debentures as part of holdings can hedge your risks and maintain stability, overall. Innovative products such as exchange-traded funds (ETFs) can also offer more diversification to your portfolio by investing in a pool of stocks with varying proportions.
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FAQ
Shares represent a portion of the company's capital, and give you a form of ownership in the company, as a shareholder. On the other hand, debentures are a type of debt instrument that represents a loan to the company.