About Non Convertible Debentures (NCDs)

What are NCDs?

One of the many ways for a company to borrow funds is through NCDs or non convertible debentures. Debentures by nature are debt instruments and as the name says they are non convertible. Like the name suggests they cannot be converted into equity after a defined period of time. Another kind of debenture is the convertible debentures which, as the name mentions, are converted into equity after a certain period. They like other debt instruments, have an interest rate and a tenure. The interest can be paid out monthly, quarterly, annually or at maturity. NCDs are generally listed on the exchange. The prices of such NCDs would vary according to the prevailing interest rates. If the interest rates rise, the price of the bond could fall.

What are the different kinds of NCDs?

Within NCDs, there are two types: secured or unsecured. Secured NCDs have physical assets like the company's property or plant as collateral. The security serves as a guarantee to investors in case the company defaults on its obligations, the assets can be liquidated to pay investors’ dues. Of the two, secured NCDs are considered to be slightly lower on risk since they have an asset backing them. This is one of the important factors which investors should consider before investing into an NCD.

Why Debt as an asset class?

NCDs, Fixed deposits, debt funds etc are all part of the asset class of fixed income. The purpose of investing into debt is for stable returns without high level of volatility as seen in equity. Addition of a fixed income investment also reduces the overall volatility of your portfolio. Equity and debt as asset classes are known to move in opposite directions i.e. they have low correlation. Assets with low correlation are overall good for the portfolio. When one is doing badly, the other is doing well and vice versa. This is why debt is good for the portfolio as it adds an element of diversification to your porfolio.

With the current equity markets facing extreme volatility on account of various global and domestic factors, debt as an asset class proves a good option for investors looking out for stable returns along with protection of capital. Amongst the many ways one can invest in debt is through NCDs which are similar to fixed deposits in nature but offer higher interest rates along with higher levels of risk.

Why NCDs now?

After the recent hike in interest rates by the Reserve Bank of India (RBI) in its last monetary policy on 20th September, the case for investing in NCDs becomes even more attractive. Indian markets have been facing some stress on account of the domestic currency depreciation along with various activities by central banks of the world to curb the liquidity crunch and stabilize markets. To add to this, we have seen severe volatility of the front of the government securities yield. Another important factor which we need to consider is the wholesale and consumer inflation, which has been very high of late.

All these events have seen a huge amount of liquidity crunch in the banking system. Any liquidity crunch in the system leads to short term rates increasing as there are more people chasing lesser money.

In a high interest rate scenario, NCDs offer high rates to investors albeit with higher risk. For investors seeking high yielding debt investments with moderate risk appetite, NCDs could be the answer.

6 points to note before you invest in a NCD

1. Don't go for the brand...research the company
   If you plan to invest in an NCD, it is only fitting for you to research the company’s background. Look for instances in the past of the company raising money and whether it has met its obligations. Merely going by the brand is not a wise move while investing in NCDs. There have been many instances of established companies defaulting on their obligations. Of course, there are independent rating agencies like CRISIL, ICRA which evaluate companies on these parameters. An NCD with a rating of “AAA” by rating agencies implies the highest level of safety of repayment of capital and interest rates. But investors must also do their own homework. Research of such nature is widely available on the internet and should not be seen as daunting and burdensome. It's your money and this is the least you must do to protect it.
2. Credit rating and not only rate of return
   NCDs usually offer a rate of return that is higher than fixed deposits (FD). This is particularly so if it is unsecured. Investors usually go for NCDs due to the higher coupon rate. Ensure that the higher coupon rate is backed by top notch credit rating and security i.e. secured NCDs. If they are not secure, then you must consider whether your risk appetite and investment objectives permit you to invest in them.
3. Interest option
   NCDs are available with various options for interest payout with annual and cumulative payout being the most common options. The cumulative option is most rewarding since the interest is reinvested and investors can benefit from compounding. The payout option is suitable for investors who prefer to receive regular income.
4. Consider post tax returns
   No tax is deducted at source (TDS) in case of an NCD traded on the exchange. The interest income is added to the investor’s taxable income under the head 'Income from other sources'. The income will be taxed at the marginal rate of tax applicable to the individual. In case the investor exits the NCDs before a year, the income generated is taxed under short term capital gains tax. If he exits after a year and before maturity he will have to pay long-term capital gains tax on the interest income.
5. Liquidity Risk
   Most NCDs are listed on the stock exchanges and are available in demat form. Although this means they are liquid, the volumes in NCDs are very thin. Hence in case you wish to exit, it could become very difficult to find a buyer. Further in case you find a buyer, you might have to sell it at a discount.
6. Repayment or Credit risk
   Before investing in an NCD, one must consider risks inherent to such investment. The biggest risk that an investor might face is credit risk. This means that the issuing company may default on returning the capital invested, the interest or both. In case of an unsecured NCD, this risk becomes even more critical since there is no asset backing from the issuer. Hence it is suitable to go in for higher credit rating like AAA which is considered to have the highest level of safety.

Who should invest in a NCD?

An investor who is looking at debt investments and is willing to take moderate amount of risk could consider an investment into NCDs. But you should consider your risk profile before considering an investment. Since NCDs by nature are considered more risky than traditional fixed deposits, they offer relatively higher rates. If you are looking at making a diversified debt portfolio, investing in an NCD could make sense. You could consider taking a small exposure of your entire debt portfolio to invest in NCDs.

NCDs versus bank deposits

Other than providing higher post tax returns, NCDs are available for longer tenures. A fixed deposit is offered to up to 7-10 years, while a NCD is available for a maximum of 20 years. Although NCD prices are market linked, for an investor willing to take a little more risk, NCD could be a good option.

Features	Bank Fixed Deposit	Secured NCDs
Rating	Not Applicable	Mandatory by rating agencies
Liquidity	Pre-mature withdrawal possible but at penalty	Can be sold over exchanges without penalty, if listed
Safety	Secured up to INR 1 lakh	Secured against issuing company’s assets
Tax Deducted at Source (TDS)	TDS deducted if interest is above INR 10,000	No TDS
Taxation	As per tax slab	As per tax slab, also capital gains if exit is before maturity