Nowadays, you must be seeing few Non
convertible Debentures (NCDs) are lining up one issue after another. In fact,
most of the investors get lured by the high rate of interest offered by these
NCDs and wanted to invest into the same. But does each of the investors
understand the concept of NCD is and how it works? Read the fine print.
Unlike, convertible debentures, Non
convertible debentures (NCD’s) are those debentures which are not convertible into
equity shares and carried with specified coupon rate payable in four options:
monthly, quarterly, annual and cumulative interest. The tenure of the NCDs can be anywhere
between 2 years and 20 years. They are listed on stock exchanges, hence,
provides liquidity to holder. Such debt bonds are normally rated by credit
rating agencies like CRISL, CARE and ICRA.
Types of NCD
A NCD can be secured and unsecured as
specified by the company. Secured NCD are backed up by some assets which can be
liquidated for paying off the bond holders in case company is in financial
crunch. For this reason, the returns on secured NCDs are lower than unsecured
NCDs.
On the flip side, unsecured NCD are the ones
which are not backed by any assets and in case something goes wrong, there can
be an issue in paying back the bond holders. Only after the payment is made to
every entity which has some security, the unsecured NCD bond holders have any
chance of getting back their money. So that’s the reason why these NCD’s have
high interest rates.
Offer High
Interest than Fixed Deposit
Undoubtedly, NCDs
provide you the opportunity to earn 2-3 percentage points higher return than
other fixed-income instruments such as bank fixed deposits, being a retail investor, you are indeed spoilt for
choice. However, in the current economic environment the negatives
and risks outweigh the 200 basis points premium the issue has over fixed
deposits. Fixed deposits for three years and five years are currently giving
around 9-9.5%.
A plain
comparison on returns would suggest no scope for debate, as several companies
issuing NCDs are promising double-digit rates, much more than bank or company
FDs. But wait before taking a decision, as the apparent returns are just one
way of looking at things. The risk element also needs to be considered. Also Read: How can go for Company Fixed Deposits Schemes?
Source: Valueresearchonline
An investment
offering higher returns invariably comes with additional risk. The biggest risk
with NCDs is the possible capital loss in case of increase in interest rates. NCDs
have a fixed coupon or interest which is paid to the holder of the instrument
at maturity. If you sell an NCD in the secondary market when the interest rate
is higher than that being offered by the debenture, your return will be less or
even negative as the buyer will pay only that amount which allows him to get
the return equal to the prevailing market rate. If the interest rate goes down,
your effective return will be higher than that being offered on the NCD.
Apart from the
risk of lower return or loss of capital, there is the risk of default by the
company even though the chances are low as most of the firms are under
supervision of the RBI and SEBI.
Liquidity Crunch
NCDs are also
listed on stock exchanges. This allows investors to liquidate the bonds even
before maturity. However, there is no active market for NCDs on the wholesale
debt market segment of the stock exchanges and their liquidity is low. You
might not be able to find a buyer for your NCDs if their trade volumes on exchanges
are insignificant as you may have to wait till maturity.
Taxation on
NCDs
Taxation on NCDs is just like debt funds. If
you sell your debentures before a year, the profits will be added to your
income and you will pay taxes at the same rate as per your income tax slab. But
for any profit made by selling it after a year, you will pay tax of 10%, without
indexation benefit, or 20% with indexation benefit, being the nature of long-term
capital gain. Also Read:Higher Tax Bracket: Think Tax-free Bonds
Evaluation
of NCDs
Though, the NCDs issues becoming more opaque
with each passing day, investors should evaluate a NCD and see that what are
key indicators based on credit rating realizing that credit rating may change
multiple times during the span on a NCD that they need to look into. Besides,
an investor should also look business areas of the company and the purpose for
which the amount is being raised also needs to be checked. One should keep
exposure limited in high coupon NCDs and depending upon risk appetite, decide
exposure in these NCDs and keep in mind at following points.
·
Check the Credit Spread of
NCD offer
·
Look at the past performance of similar NCDs of the company
·
Analyze Interest coverage Ratio of the companies offering NCDs
·
Check the Capital Adequacy Ratio
·
Check non-performing assets (NPAs) of the business
Should you
invest in them?
At present, the lure for investors is high. They
are always on the prowl for good investment opportunities. Before taking the ride
on the NCDs, investors must be considered, firstly on their financial goals and
asset allocation and then on their risk-reward profile. They should
not fall prey to the temptation just because these are offering good interest
rate because they should understand the risk involved in this as compared to
bank’s fixed deposit. But consider your comfort
with the company fundamentals and industry before you buy. Also Read: Spend Time while buying financial products!
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