Term Of The Week: Non-Convertible Debenture aka NCD

By | August 29, 2016

Term of the Week - Non-convertible debentures

It’s in the newspapers pretty often. We are sure you have heard of this term. Some of your family members or friends might even have suggested that you invest in a Non-Convertible Debenture (NCD) and that it is safe. What is the hype all about? Is it worth a look? Read on to find out.

What is an NCD?

NCD is a fixed-income investment that has a fixed tenure and interest rate. It is issued by a company as a means of raising capital. As the name suggests, they cannot be converted into equity shares like convertible debentures.

Why are companies issuing NCDs?

The value of NCDs that have hit the market since the start of 2016 has already crossed Rs. 5000 crore. Another Rs. 500 crore is in the pipeline. With loan rates falling slowly and equity markets remaining volatile, companies are taking the NCD route to raise money. No wonder, mobilisation through NCDs has gone up significantly in the past few years.

What are their features?

NCDs are offered through an open issue and you need to purchase them within the offer period. However, you can purchase them from stock markets after they are listed. To enhance liquidity, they are most often listed on stock exchanges. Also, NCDs are rated by credit rating agencies. Obviously, the highly rated ones are preferred over others. Also, the highly rated NCDs will provide lower interest when compared to the low rated ones. These ratings are usually revised from time to time based on the financial standing of the firm.

Most NCDs offer both the interest payout and growth or cumulative options and you could choose one based on your financial needs. Generally, NCDs provide better returns than traditional debt products like bank Fixed Deposits (FD) and Government bonds. With current NCD rates at 9%-11% and FD rates at 7%-8% per cent, the post-tax rates for the former will be 6%-7% and for the latter it would be lower at 5%-6% (if you are in the highest tax bracket). NCDs are ideal for those in the 10 and 20 per cent tax brackets as NCDs are taxed as per your tax slab and the lower your tax bracket, higher would be the returns.

But it is important to compare NCDs with deposits, both bank and corporate, to understand whether it is worth investing in them.

Fixed Deposits vs. NCDs

A number of investors are ignorant of the fact that corporate deposits are very different from NCDs. Corporate deposits are unsecured, that is, they are not secured against the assets of the company, whereas NCDs can be secured or unsecured. While NCDs are traded on stock exchanges; there is no easy exit route for corporate deposits. Most companies state, in their deposit application form, that repayment of the Fixed Deposit, if withdrawn prematurely, is at the discretion of the company. Sometimes you might not receive the money even on maturity. Take the case of Asha, who invested in a company FD. Her FD matured in December last year but she is yet to receive the money. So, getting your money back can be quite tough if no proper procedure is laid down by the deposit taking company. While there is no Tax Deducted at Source (TDS) for listed NCDs, interest on corporate deposits would be subject to TDS if the interest exceeds Rs. 10,000. So, NCDs might be a better option when compared to corporate deposits. But are they better than bank FDs?

You must already know that bank FDs are covered under the Deposit Insurance and Credit Guarantee Corporation’s scheme. This is for all your deposits with a particular bank for an amount up to Rs.1,00,000. There is no such guarantee for NCDs. Also, FDs are more liquid than NCDs as you can withdraw your money at any time. Some banks don’t even charge a penalty for premature withdrawal. NCDs have several disadvantages like lower liquidity and higher risks and therefore caution should be exercised before investing in them.

Additional Reading: How Safe Are Your Fixed Deposits?

Liquidity – As we told you, NCDs are listed on the stock exchanges and you can choose to exit through this route. However, note that the trading volumes are pretty low even for sought after NCDs. Consider this: The daily volume for popular names can be as low as 1 and the highest daily volume usually does not exceed 1000. Compare this to shares that are traded in lakhs and you will understand why selling your NCD is not going to be easy. You should find takers for them, right? The situation could be worse wherein the NCD is not traded at all. So, understand that exiting NCDs is not going to be easy.

Higher risks – The main risks that are associated with NCDs, especially those issued by Non- Banking Finance Companies (NBFC), are business risks and credit risks. Business risks are those risks associated with running the business. These might go up with a slowdown in the economy and tighter funding options. NBFCs are the most affected because banks are wary of lending to such companies during growth slowdowns. A growth slowdown will also mean that the margins of businesses will get affected. When revenues get hit, the interest payment on your NCD might also get hit. This would also lead to higher credit risks. Credit risk is the risk associated with the borrowings of the firm. During slowdowns there are risks of downgrades by credit rating agencies. As you know, NCDs are rated by rating agencies and if the company doesn’t do well, these ratings will face a downward revision. So, it is important to thoroughly analyse the company that is issuing the NCD. Here are the factors that one should look at:

  • Capital Adequacy Ratio (CAR) – This ratio is used to measure the capital of a company, especially that of a bank or NBFC. This is calculated as a percentage of the firm’s risk weighted assets. Capital adequacy ratio, as the name suggest, helps evaluate whether the company has a cushion or adequate funds for future losses. A CAR of more than 15% is necessary. It is also important that you check whether the company has maintained this ratio over the years.
  • Bad Debts – Always check the company’s asset quality before you invest in its NCDs. NBFCs are especially vulnerable to non-performing assets or bad debts. This is because they do a lot of unsecured lending. It is best to avoid firms that practice unsecured lending of over 50%. Also, make sure that the firm has made provisions for its NPA. A provisioning of over at least 50%-60% is necessary for NPAs. And remember that a decline in asset quality should be taken as a warning sign and investing in NCDs of such firms should be avoided.
  • Interest Coverage Ratio – As you might know, this ratio is used to ascertain whether the company is in a good position to pay off the interest on its debt. One needs to use the earnings and the interest expense of the firm to calculate this ratio. If the ratio is 2.5 or more, it indicates that the company is in a reasonable position to deal with any possible defaults in the future.
  • Credit Rating – You must check the credit rating of the NCD issue before you invest in it. It is best to look at only those NCDs that have a rating of at least AA. Credit rating will tell you whether the company is in a positon to honour its debt commitments such as interest and principal repayment. Credit rating agencies estimate the company’s capacity to generate cash from its operations while checking if the inflows are sustainable over the tenure of the NCD issue. Healthy cash flow will mean that the company is in a good positon to meet its debt obligations. The financial standing of the firm will be taken into account before a rating is awarded to the NCD issue.

The question is what are the most important factors used to arrive at the rating? The most crucial bit of information is the degree of risk exposure the firm has. This will include financial as well as business risks. Credit rating agencies conduct calls with the company’s management to understand the business as well as learn about the future growth prospects of the firm. If financial and business risks are high, the rating for the NCD will be low. As an investor, you should understand that investing in a low rated NCD will mean high risks for you. However, note that the process will be different for short-term and long-term ratings. Cash flow will become more important if the credit rating agency has to give a short-term rating. For longer term ratings, the management quality and the performance of the firm among peers will be taken into account. You can see that the credit ratings will be different for different investments issued by the same firm. Consider your risk appetite and choose the NCD that has ratings that suit your appetite. Note that the risks of default increase significantly for those NCDs that are rated below AA.

Make the most of your investments

Here are ways in which you can get the best out of your NCD investment.

  • Every business raises money through NCDs for a particular purpose. Ideally, the money raised should be used for the core business operations of the firm. If the terms are not clear, it is best to avoid investing in such NCDs.
  • As mentioned earlier, there are secured NCDs and there are unsecured NCDs. It is beneficial to invest in the former. Secured NCD issues are secured against the assets of the firm. This means that you will be given preference if the firm goes into liquidation or in simple terms, shuts down.
  • NCDs are not liquid. So, it is best to look at investing small sums that you may not require until the maturity of the investment. You can invest across companies and tenures so that your risk is well spread.
  • Avoid investing in NCDs from a single industry such as NBFCs that give gold loans. This way, you expose yourself to industry risk. If the industry is underperforming, it is possible that the companies that issued the NCDs might default all at the same time.
  • If you are looking for high returns, you can consider buying NCDs from the secondary market. NCDs could trade at a discount in the secondary market, that is, the equity market. When a company is ready to issue an NCD, its old NCDs that have a lower coupon rate will start trading at a discount in the market. The best way to invest in NCDs in the secondary market is by looking at their yields. This will factor in the tenure and the price of the NCD. If you invest looking at the interest rate, you might actually lose out. It is possible that the interest rate is high but the yield of the NCD is low. So, always look at the yield, which tells you your actual returns, before investing in a NCD.
  • If you want to sell your NCD in the market, the best time will be when the NCD’s interest payment becomes due. An NCD will usually trade at a premium before an interest payment becomes due and this will mean more profits for you. You will find that more NCDs are trading at a premium now. This is because interest rates are falling. When interest rate in the country falls, the earlier NCDs issued with higher interest rates will be sought after. So, these NCDs will quote high prices in the market. Note that such premiums could be anywhere between 5% and 20% or higher.
  • What should you do when the rating of your NCD is downgraded? Should you sell it immediately? First check if the NCD still meets your risk appetite. Seek information on the company and check if there has been any negative news that has led to the downgrade. Assess if this negative news will have a long-term impact. If you find it tough to take a call, take the help of a financial expert.

By now you must have understood that NCDs are meant only for those with a high risk appetite. If you are someone who keeps worrying about your principal, this might not be the investment for you. You can choose Fixed Deposits from banks that are safe and give stable returns. Exiting from them is also very easy. Unlike NCDs, you can choose the tenure that suits you. Need we say more?

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Category: Money Management

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