A guide before you invest in NCDs

By Larissa Fernand |  18-01-19 | 

It’s raining NCDs. Again.

Actually, it has been doing so for a while.

In 2011 and 2012, firms came out with NCDs offering returns in the 11-12% vicinity. One issue in 2011 that I randomly recollect is the NCD of Shriram Transport Finance Corporation. Offering a return of around 11%, the Rs 500-crore NCD issue was oversubscribed about five times in just three days. The company had reserved Rs 200 crore worth of NCDs for retail investors (investment under Rs 5 lakh), but the firm received applications for Rs 2,300 crore in this segment.

The year 2018 also saw a fair number of NCDs hit the market. A trend that is continuing into 2019.

Here’s what to keep in mind when deciding for or against them.

Do they fit into your portfolio?

Are you over allocated to debt? And specifically, over exposed to fixed return instruments? Fixed return investments would include the likes of Public Provident Fund (PPF), National Savings Certificate (NSC) and bank fixed deposits (FDs).

If you are looking to increase your allocation to this segment, then go ahead and give the Non-convertible Debenture (NCD) due consideration.

Now let’s narrow it down.

An FD or NCD?

While PPF and NSC have tax benefits under Section 80C and are backed by the government, the NCD is often weighed in on a comparison with bank FDs. (The 5-year bank deposits also have a benefit under Section 80C).

Undoubtedly, they are great alternatives to bank FDs, specifically when talking of the assured return. Both pay a specific return for a fixed tenure. The interest rate, in the case of an NCD, would be higher.

Hence on the return front, the NCD scores.

Having said that, the taxation treatment is identical. Interest earned for the FDs and NCDs is added to total income and entirely taxable as per the relevant income tax slab.

It is for this reason, that they are favourable only for those who fall in a lower tax category. For instance, let’s assume that the NCD offers an annual return of 9.30%. If you fall in the 30% tax bracket, your return would be around 6.51% (not taking any cess or surcharge into account).

When it comes to tenure, you could get more variation with a bank FD and the option of a much shorter tenure. For example, the current Mahindra Finance NCD offer has four tenures: 39 months, 60 months, 96 months and 120 months. As you can see, you need to approach NCDs with a long tenure in mind.

Also check the payments of interest - quarterly, half-yearly, annual or cumulative.

Choosing between NCDs

Debentures are long-term financial instruments issued by a company for specified tenure with a promise to pay fixed interest to the investor.

Convertible debentures are hybrids – part bond, part stock. They are attractive because they promise the security of a bond coupled with the option to convert to equity should the stock price rise. They could be partly convertible or fully convertible.

In this article, we are specifically ONLY referring to NCDs, which will always remain a debt instrument and never have any equity component.

The NCDs can be secured or unsecured. A secured debenture is secured by the charge on some asset or set of assets. Basically, backed by the issuing company’s assets to fulfil the obligation. When it is issued solely on the credibility of the issuer, it is known as an unsecured debenture.

The claims of the secured NCD holders are superior to the claims of any unsecured creditors. The unsecured NCDs are not secured by any charge on the assets of the company and will be subordinate to the claims of all other creditors. Hence, secured NCDs are safer. To compensate for that, unsecured NCDs generally offer a slightly higher return.

(Under the Financial Resolution and Deposit Insurance (FRDI) Bill, bank deposits are insured under the Deposit Insurance and Credit Guarantee Corporation (DICGC). Each depositor in a bank (across all branches) is insured up to a maximum of Rs 1 lakh for both principal and interest.  amount held in the same capacity and same right. Thus far, the regulator has not allowed any bank to fail and deny its clients their due.)

And when it comes picking the right instrument, do consider the financial strength and stability of the company. As a retail investor, don’t overlook the rating given by the external rating agency (CRISIL, ICRA, CARE, Fitch). An NCD must be rated by at least one credit rating agency.

In conclusion….

NCDs can be traded in secondary market. However, the debt market is not the best for individual investors when it comes to liquidity. So don’t buy NCDs with the aim of trading on the interest rate cycle. Buy and hold till maturity.

Only if you need to allocate funds to the fixed income portion of your portfolio, and you are looking for an alternative to a bank FD, you should consider an NCD. Most preferably, you should fall in the lower tax bracket.

Don’t go overboard in investing a huge chuck of your money, after all you allocating money to one single company. Also avoid locking in your money for very long time of, say, 8 to 10 years.

Since the NCD issue process is similar to the IPO process, you will have to have a demat account with a brokerage house to buy an NCD.

My final advice to the retail investor is to discuss your choice and preferences with a financial adviser. Do read Do you need a financial adviser? for more clarity.

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