Non Convertible Debentures (NCD): Meaning, Taxation, Interest Rate, Example

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. 

What is 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.

Example of NCDs: You can invest when the company announces NCDs or purchase after it trades on the secondary market. You must check the company’s credit rating, issuer credibility and the coupon rate of the NCD. It would help if you purchase NCDs of a higher rating such as AAA+ or AA+. 

Features of NCDs

Taxation

NCDs carry tax implications depending on the tax bracket the investor falls under. If NCDs are sold within a year, STCG will be applicable as per the income tax slab rate. If the NCDs are sold after a year or before the maturity date, LTCG will be applicable at 20% with indexation. The interest income from NCDs is taxed in a similar manner as fixed income securities under ‘income from other sources. Let’s calculate the post-tax return from the NCD:

Credit rating:

Companies are ranked by credit rating agencies such as CRISIL, CARE etc. To determine the potential of a company, its rating plays a major role. A higher credit rating means that the company has the ability to fulfil credit obligations. However, a 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 a lesser ranking. 

Interest:

NCDs may offer a high-interest rate ranging from 7% to 9% if held till maturity. Interest payouts are either monthly, quarterly, half-yearly or annually. NCDs do offer a cumulative payout option, as well. Moreover, unsecured NCDs can offer a higher interest rate.

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 NCD.

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.

Level of Debt:

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.

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.

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.

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.

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.

Difference between Corporate FDs and NCDs

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.

Tips for investing in NCDs

• 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.
• Diversification, i.e., investing across various firms and periods can reduce the risks considerably. 
• NCDs from one single sector (NBFCS that focuses on personal loans) are not safe to invest in. This can lead to higher risk exposure.
• 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. 
• Never go by the interest rate alone. It will not matter if the NCD yield (that decides your real returns) remains low. 
• 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.

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