Your Money: All about bonds, debts and debentures

By Sunil K Parameswaran

Bonds are not as high profile as most blue-chip stocks, and consequently most investors are not aware of them. Bonds are an alternative to stocks for companies seeking to raise capital. They represent a promise by the issuer to pay periodic interest to the holder, and to repay the principal at a pre-specified maturity date. There are exceptions. Zero coupon bonds do not pay periodic interest, and the sum of the principal and interest is paid out at maturity. Perpetual bonds have no maturity date. They will pay interest forever and will never repay the principal.

Companies use bonds to obtain capital without diluting the stake of the shareholders. They are an alternative to bank loans, which are an alternative source of debt capital for companies. Bonds provide leverage. That is, since they pay a fixed rate of return, the rate of return is magnified for equity shareholders. However, leverage is a double-edged sword, that is, both positive and negative returns are magnified.

Interest on bonds is a tax deductible expense for a company, unlike dividends on shares, and consequently provides the issuing company with a tax shield. Thus, debt capital is generally considered to be cheaper than equity capital for the issuer.

Secured or unsecured bonds
Bonds may be secured or unsecured. The former are backed by specific collateral, such as land, buildings, or plant and machinery. If the issuer cannot make a promised payment, the holders of secured debt can have the collateral liquidated to recover what is owed to them. Unsecured debt holders can only hope that the issuer will have adequate resources when the time comes for repayment. In the US, secured debt is called a bond and unsecured debt is termed as a debenture. In India we use the terms interchangeably. Consequently, if someone mentions the word debenture in India, we need to inquire whether it is secured or unsecured.

If a company is liquidated, the pecking order for payments is as follows. Secured debt holders are paid first, followed by unsecured debt holders, who are followed by preference shareholders, if any. Obviously, the equity shareholders are the last to be paid, if there is a residue, and are consequently known as residual claimants.

Equity shares are generally listed and traded on stock exchanges. While some bonds are traded on stock exchanges, the majority trade over the counter (OTC), in a market made by dealers. Some debt securities cannot be traded and are said to be non-negotiable. For instance, a National Savings Certificate (NSC) that is used by Indians for tax saving purposes, and fixed deposit receipts, held by individuals cannot be traded. If a person needs money, he can pledge his NSC and borrow, but an NSC or fixed deposit receipt cannot be endorsed and transferred to another person.

Unlike a stock owner who may sell to capture a capital gain, most bondholders will hold on to them until maturity, while collecting the periodic interest payments.

The writer is CEO, Tarheel Consultancy Services