There are a number of financial instruments available in the market through which firms are able to raise funds. While shares increase the capital of the company, debentures add up the debt of a company. These same instruments also help investors by providing avenues for them to invest their money in. However, they are both very different in several aspects like level of profits, associated risk, and so on. Investors often prefer to invest in both of them so as to diversify their investment portfolios and bring down the level of risk. But deciding the proportion to invest in each can get a little tricky. Let’s help you decide!
What are Debentures?
Debentures are debt instruments. Here, it is as if you personally are giving the company a loan in exchange for some pre-decided amount of interest rate. The principal amount will be returned to you after a certain maturity value. Debentures are long term debt instruments used by firms to raise funds without having to give up ownership rights. While it is like a loan in every other way, one major difference is that it is not necessarily backed up by any collateral. The only collateral is the intangible creditworthiness of the firm. However, it carries a lesser degree of risk than shares since, according to the law, when a company files for bankruptcy, the company is obligated to pay off its debenture holders first before it can pay its shareholders.
Types of Debentures
There are different kinds of debentures.
a) Perpetual Debentures
The first kind is a perpetual debenture. Here, there is no maturity value. A perpetual debenture holder can hold these for as long as they wish and create a lifelong source of income for themselves. These are very similar to equity shares and can be traded in markets, just like shares.
b) Convertible Debentures
The second kind is the convertible debentures. Here, investors can either choose to collect the maturity value or convert their dividends into equity shares. Lastly, the exact opposite are non-convertible shares wherein investors have no choice but to collect the maturity value and the accrued interest at the time of maturity.
Debentures can also differ in terms of interest rates. Some have fixed rates while some have floating rates. In the former, the final amount received remains the same regardless of the fluctuations in the market while in the latter, the final amount received depends on the fluctuations. Naturally, fixed interest rate debentures are more secure.
What are shares?
Shares on the other hand grant you a stake, or an ownership claim, to the company whose shares you are purchasing. You may or may not receive periodical dividends in this case. When companies sell shares to the public, they raise funds through offering ownership to the investors. Here, investors have a claim to the profits earned by the issuing company.
Types of Shares
In shares too, there are different kinds- preference shares and equity shares.
a) Preference Shares
Preference shares are like a mix between equity shares and debentures. Preference shareholders do not have any claim to profits, they are paid fixed dividends. But in the event of bankruptcy, they are paid off before the equity shareholders. Their dividends are cumulative in nature, as in, if a company is unable to pay dividends in a particular year, the company is still liable to pay the unpaid dividend the next year along with the current year’s dividends.
b) In equity shares, investors are privy to dividends (if profits allow), bonus issues, rights issues and more. Investors get to participate in the decision-making process of the company. Sometimes, when the company makes massive profits, they end up with major dividends unlike debenture and preference share holders who receive a fixed amount irrespective of the level of profits. However, in cases of no-profit or losses, investors receive nothing. Their dividends are not cumulative either and they receive last preference in pay-outs in the event of a bankruptcy.
There are further subdivisions under both equity and preference shares based on their nature. Another point to be noted is that while preference shares can be converted into equity shares, the reverse is not possible.
Where should you invest? Shares or Debentures?
When it comes to the question of what you should invest in, there are a few factors that need to be taken into consideration. However, the main factor is always the level of risk the investor is willing to bear. Clearly, debentures are the best option for risk averse individuals since they get a fixed amount which is unaffected by market fluctuations, are paid off first in case of adverse situations, have excellent ratings on the financial instruments market (debentures are generally rated AAA but it also depends on the company.) They might also have the option to convert their debentures into equity. However, when individuals are more risk-taking or have utmost confidence that a firm will run profitably and pay its investors well, they prefer to invest in equity. The sense of ownership and involvement in decision making also adds to the appeal. Also, while shares are transferable, not all dividends are transferable. So, relatively, shares are more liquid than debentures since an investor is free to sell their shares whenever required to free up their investments while debenture holders do not have this option.
Generally, it is recommended that one should invest in a mix of stocks and debentures so as to diversify and mitigate the level of risk. But in the end, your investment decisions should be made not just according to your risk appetite, but also according to the fundamentals and potential of the company you invest in and whatever best suits your overall financial plan.
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