An 11-12% fixed return to investors is a very tempting offer to resist when equities are not doing well. Not many fixed income instruments are able to deliver such high returns. But in last few years companies have raised good money through Non-Convertible Debentures (NCDs). The main attraction was high return to investors in comparison to other fixed income instruments like bank deposits.
Let us take a look how NCDs work and what should be the criteria to judge the right one:
What are NCDs
Whenever a company wants to raise money from the public it issues a debt paper for a specified tenure where it pays a fixed interest on the investment. This paper is known as a debenture. Some of the debentures are termed as convertible debentures since they can be converted into equity share on maturity. A Non - Convertible debenture or NCD do not have the option of conversion into shares and on maturity the principal amount along with accumulated interest is paid to the holder of the instrument.
There are two types of NCDs-secured and unsecured. A secured NCD is backed by the assets of the company and if it fails to pay the obligation, the investor holding the debenture can claim it through liquidation of these assets. Contrary to this there is no backing in unsecured NCDs if company defaults. However, any company seeking to raise money through NCD has to get its issue rated by agencies such as CRISIL, ICRA, CARE and Fitch Ratings. A higher ratings (e.g. CRISIL AAA or AA-Stable) means the issuer has the ability to service its debt on time and carries lower default risk. A lower rating signifies a higher credit risk.
Interest Rates in NCDs
In high interest rate scenario, NCDs offer high rates to investors. The average rates in last few years have been 11-12%. Most of thesewere secured NCDs. Also, companies which carry higher risk give more than others to lure investors for investment. There can be various options for interest payout such as monthly, quarterly, half yearly or annually. However, most NCDs offer annual and cumulative payout. Investors wish to earn higher returns opt for cumulative option where the interest is reinvested and paid at maturity.
NCDs get listed on stock exchanges where investors can sell it before maturity. Any gain earned through selling in secondary market is termed as capital gains. What gains an investor
will make depends on the interest rate scenario. If interest rates are higher than offered by NCD then the returns will be lower if sold through secondary markets and there might be negative return for investors in some cases. However, if there is fall in interest rates after buying NCD then selling on stock market may prove beneficial as the NCD will demand a premium.
The interest earned on NCD is clubbed with income of the bond holder and is taxed at individual marginal income tax rate. The capital gains have different taxability. Short term capital gains which arises by selling NCD before one year is taxed as per the income slab of individual holding the instrument. Any gains which arises by selling NCD after one year and before maturity is taxable as long term capital gains. The applicable tax rate is 10.30% without indexation since cost indexation benefit is not available in case of bonds and debentures.
NCDs have some inherent risk associated which an investor has to take into consideration before making any investment decision. The biggest risk is the credit risk. The company can default on the future payment and if it is unsecured NCD, an investor does not have any recourse. Most companies get rating through agencies like CRISIL or CARE based on various parameters which investors can check for credibility. A rating of AAAby CRISIL is considered to be highest on safety. The second risk is the liquidity risk. Even if NCD get listed, low volumes (case of low rated NCDs) can deprive investors of any opportunity in exiting prematurely.
Investor should pre-check certain factors before selecting any NCD for investment. Look at the companys financial health and end uses of funds. Any diversion from core business can be a worry factor. Check rating of companies which gives an idea of safety of your investment. A recent report by CRISIL states that no single instrument with AAA rating has ever defaulted while it has grown with lower rating bonds. Also, companies with low ratings offer very high returns and its difficult to resist our temptation. Avoid such situation and review overall financial health of companies. Lastly, look at post tax returns as higher taxability reduces returns from NCDs too and for 1% more than FDs, risk may not be worth taking.
The author is a Certified Financial Planner and founder of JS Financial Advisors. You can reach him at firstname.lastname@example.org