A bond is one of the methods of obtaining debt. Under the bond, the issuer issues a promissory note ( written instrument) promising to pay the principal amount at maturity as well as interest on the principal on regular intervals.
“A bond is a written instrument of acknowledging the debt under the common seal of the business / company.”
In businesses, funds are quite frequently required for smooth operations or growth of businesses. There are two prime methods of generating such funds
- Obtain funds from owners of the business i.e. equity contribution and pay return in the form of dividends.
- Or obtains funds in the form of debt from third parties and pay return in the form of interest.
There are several options of obtaining debt from third parties e.g.
- Obtaining loan directly from banks or financial institutions by entering into a agreement or
- Issuing a piece of paper (i.e. a bond) by the business promising to pay the principal as well as interest on the principal for a certain length of time as promised on the piece of paper. (see diagram of bond below)
Since bonds can only be issued after complying with laws, rules and regulations therefore bonds are enforceable by law in the event of default of the promissory. That is why only companies / corporations / governments can issue bonds and a common person cannot.
Moreover investors of bonds usually have some protection as well in the case of default by the issuer e.g. right in the real state (building) of the business etc.
Difference between bonds and debentures
At times, the terms of bond and debenture is interchangeably used which in my opinion to some extent is correct.
Bond is the more general term used for long term debt written instruments
Whereas debenture is a type of bond used more specifically for unsecured long term bonds. By unsecure we mean there is no protection for investors in debentures in case of default by the debenture issuer.
Example of a bond
Following image shows an example of the debenture.