Non-convertible debentures (NCD) are fixed-income instruments, usually issued by high-rated companies in the form of a public issue to accumulate long-term capital appreciation. They offer relatively higher interest rates when compared to convertible debentures.
This article covers the following:
1. What are Non Convertible Debentures (NCDs)?
Non-convertible debentures fall under the debt category. They cannot be converted into equity or stocks. NCDs have a fixed maturity date and the interest can be paid along with the principal amount either monthly, quarterly, or annually depending on the fixed tenure specified. They benefit investors with their supreme returns, liquidity, low risk and tax benefits when compared to that of convertible debentures.
2. Features of NCDs
NCDs carry tax implications depending on the tax bracket the investor falls under. If NCDs are sold within a year or lesser STCG will be applicable as per the income tax slab rate. If the NCDs are sold after a year or more or before the maturity date, LTCG will be applicable at 20% with indexation.
b. Credit rating
Companies are ranked by credit rating agencies such as CRISIL, CARE etc. To determine the potential of a company, it’s rating plays a major role. Higher credit rating means that the company has the ability to fulfil credit obligations. However, low credit rating means that the company has high credit risks involved. If any issuing company fails to make payments then the rating agencies give them lesser ranking.
NCDs offer high interests. The interest usually ranges from 8% to 12%. Interest payouts are either monthly, quarterly, half-yearly or annually. NCDs do offer cumulative payout option, as well.
3. Things an investor should consider
NCDs are vulnerable to risks related to handling business and funding. Hence, the credit rating can take a hit if the turnover is negatively impacted. The company will have to borrow additional funds from banks or NBFCs to counterbalance the impact. Hence, it is advised to keep a few things in mind before opting for a company or NCD.
a. Credit Rating of the issuer
Choose a company with an AA rating or above. Credit rating calculates the firm’s potential to raise cash from its internal and external operations and its sustainability. This is the best parameter that can reveal the financial position of the company.
b. Level of Debts
Some background check on the asset quality of the company can go a long way for NCD investors. Do not invest if the company allocates more than 50% of its total assets towards unsecured loans.
c. Capital Adequacy Ratio (CAR)
CAR gauges the company’s capital and sees if the company has sufficient funds to survive potential losses. Ensure that the firm you plan to invest in has at least 15% CAR and have historically maintained the same.
d. Provisions for Non Performing Assets
The company must keep aside at least 50% of their assets towards NPAs as this is a positive indicator of their asset quality. If the quality drops due to bad debts, take it as a red flag.
e. Interest Coverage Ratio
The Interest Coverage Ratio or ICR determines the firm ability to comfortably settle the interest on its loans at any given time. This ensures that the company can handle possible evasions.
f. Your tax slab
Investors in the 10% and 20% tax slabs find NCDs lucrative. This is because you can earn more if your tax bracket is low.
4. Difference between Corporate FDs and NCDs
Before you start investing, knowing the difference between corporate fixed deposits and NCDs is crucial. Here are a few key differences between the two:
|Corporate Fixed Deposits||NCDs|
|Corporate FDs are highly unsafe, whereas, bank FDs are insured up to Rs.1 lakh.||NCDs is either secured or unsecured depending on the principal amount and interest rate issued by the company offering debentures.|
|FDs can be withdrawn before maturity with a small penalty applicable on an early withdrawal. However, premature withdrawals do not apply to all types of FDs.||NCDs cannot be withdrawn before maturity. Since NCDs are listed on the stock market they can be sold in the secondary market.|
|Bank FDs attract TDS if gains are beyond Rs.10,000.||Tax implications do apply on NCDs, capital gains need to be paid on the interest earned. However, NCDs held in Demat form are exempted from TDS.|
|Deposit Insurance and Credit Guarantee Corporation insures bank FDs (up to Rs.1 lakh).||NCDs are not insured but are secured against the company assets|
|While you cannot sell FD in the market, FDs enjoy more liquidity than NCDs||You can trade your NCD, but not withdraw it prematurely|
|No interest risk||The interest varies as per market|
5. Types of NCDs
Following are the two kinds of non-convertible debentures:
Secured NCDs: Secured NCDs are considered safer of the two kinds as their issues are backed by the assets of the company. In the event of the company failing to pay on time, then the investors can recover their dues by liquidating the company’s assets. However, the interest offered on NCDs is low.
Unsecured NCDs: Unsecured NCDs are much riskier than the secured NCDs as the assets of the company do not back these. Hence, when the company defaults on its payment, the investors have no choice but to wait until they receive payments as there are no assets of the company to recover their dues. However, the interest rate offered on unsecured NCDs is higher than that of secured NCDs.
6. Tips for investing in NCDs
a. Organisations resort to raising funds using NCDs only to meet a specific business purpose. Read the terms and conditions – if they do not offer you clarity on how/where your money is going to be used, do not invest.
b. Diversification, i.e., investing across various firms and periods can reduce the risks considerably.
c. NCDs from one single sector (NBFCS that focuses on personal loans) are not safe to invest in. This can lead to higher risk exposure.
d. NCDs from the secondary markets have always delivered higher returns in the past. This is when you buy older NCDs when a firm issues a new one.
e. Never go by the interest rate alone. It will not matter if the NCD yield (that decides your real returns) remains low.
f. The perfect time to sell your NCD is when its interest is due. It is the prime trading time for a non-convertible debenture. You can expect to make more money out of it.