NCDs offer better returns than bank FDs, but are they ideal for you?

The Non-Convertible term used along with the Debenture means investors who buy the debt instrument cannot convert them into common equity shares of the issuer company on maturity. By Nikhil Kamath

For investors not familiar with Non- convertible debentures (NCD), they are debt instruments issued by companies to raise capital with the issuer company specifying the objectives for issuing the debt. Unlike equity shares where the investor is a stakeholder of the company, in the case of NCDs, the investor is only a lender without any ownership in the company.

NCD’s have a maturity date or tenor ranging from 90 days – 20 years and a fixed rate of interest which is paid either quarterly, semi-annually, annually or on maturity. The Non-Convertible term used along with the Debenture means investors who buy the debt instrument cannot convert them into common equity shares of the issuer company on maturity.

Corporations generally offer debentures as an alternative to borrowing from the banks which can be a drawn-out process and investors buy these debt instruments since they offer a higher rate of interest compared to the “Fixed Deposits” offered by banks. When it comes to the risk component, NCDs carry a higher risk to term deposits of banks and a comparatively lower risk to buying equity shares of the company.

Term Deposits
Term Deposits are savings instruments held by retail investors with financial institutions such as banks, for a specific period. The term or maturity date usually varies from 1 month- 5 years depending on the financial institution. On maturity, the investor or depositor walks away with the capital invested and the interest accrued on it.

There is a lack of awareness among the general public in India when it comes to NCD’s. Most people prefer to go with “Term Deposits” since they consider it generally safe to park their money in banks. However, for investors with a moderate risk appetite, NCD’s are a better alternative since they offer superior interest rates when compared with most Term Deposits that are present today.

NCD’s can be directly purchased from the issuing company during the course of a public issue, which is usually open for a few days before they are registered on the stock exchanges and traded in the secondary markets. Since NCD’s eventually list on stock exchanges, investors who missed out purchasing the debentures can also buy them in the secondary markets, although the liquidity may not be very high. After an NCD is purchased, if there is a fall in interest rates, they will end up quoting at a premium, making them an attractive investment option.

Some of the parameters to consider while subscribing to NCD’s:

Reasons for offering the NCD Validate the motives of the company that is issuing the NCD and what it intends to do with the money it is expecting to receive from the issuance.

Secured/Unsecured NCD – NCD’s come with a secured or an unsecured tag attached to them. A secured NCD is backed by the issuer company’s assets to fulfill the debt obligation whereas an unsecured NCD solely relies on the credit rating to ensure the company’s ability to service the debt. Lower the credit rating, higher would be the risk and the interest on the NCD.

Return on Investment – It is always enticing when a company offers a debt instrument with comparatively good returns, but that alone should not be the reason to opt for it. It is always prudent to look for information such as the financial health of the company, performance of the management and their future plans for the company.

Risks – In spite of the level of credit rating, NCD’s are subject to credit risk, interest rate risk, liquidity risk and systematic risk.

NCD’s are traded in the secondary markets thereby providing opportunities for sellers to exit before maturity. However, in the case of term deposits, if an individual wants to exit from it prior to maturity, banks end up levying fees and penalty, thereby lowering interest rates further.

NCD’s and term deposits are savings instruments with different maturities and risk parameters. While the latter would suit investors with a low-risk profile, NCD’s carry moderate risk and may not be the investment of choice for retail investors averse to risk.

Income earned from a NCD is taxable at two levels:

► Income from other sources
►Capital gains
– Short-term capital gains if held for less than 12-months
– Long-term capital gains if held for more than 12-months

Nikhil Kamath, Co-founder & Head of Trading, Zerodha

Leave a Reply