All about investing in NCDs(Non-Convertible Debentures)
All you need to know about Non-Convertible Debentures (NCDs):
There are two types of debentures, Convertible and Non-Convertible Debentures (NCDs). These are Debt Instruments issued by companies to raise long-term capital. Non-Convertible Debentures are usually listed on the exchanges, and any Investor with a Demat Account can invest in it.
Non-Convertible Debentures can be traded in the market within the prescribed tenure. Investors can benefit from a higher rate of interest with an NCD as against a Convertible Debenture. The only catch with NCD is, unlike a Convertible debenture which offers an option to be converted to a share at a chosen time in future, an NCD cannot be converted.
Types of Non-Convertible Debentures
Non-Convertible Debentures can be classified into Secured and Unsecured:
Secured Non-Convertible Debentures are backed or protected by company assets. In other words, any failure to honor the obligation by the issuing corporate allows the debenture holder to claim the value through liquidation of assets. Unsecured Non-Convertible Debentures have no protection or backing in case of default by the company.
Considerations before investing in Non-Convertible Debentures
Few important factors that you should consider before investing in an NCD are listed below:
Rating & safety: CRISIL & other agencies provide credit ratings for NCDs. A lower rating signifies higher risk and vice versa. Thus, NCDs with a higher rating are safer. Similarly, Secured NCDs are safer than Unsecured NCDs.
Company Background: The Credit, repayment history as well as other fundamentals of the company raising the NCDs needs to be carefully studied before making any investment decision.
Liquidity: NCDs are liquid since they are listed on the stock exchange. They might have a built-in clause that allows you a premature exit, i.e. a “PUT Option”. This option can be exercised after the lock-in period, which is usually greater than 90 days.
Taxation and TDS: NCDs other than the tax-free bonds are taxed as per individual tax slabs under the head, “Income from Other Sources”. All NCDs listed on the stock exchange are not subject to TDS. Investors who exit the NCD before a year are subject to Short-term Capital Gains tax. Investors who exit after a year, but before maturity are subject to Long-term Capital Gains tax.
Rate of Return: Rate of return for NCDs is usually greater than the other debt instruments. The current rate of return is between 10-11%.
Interest payout: It may be quarterly, half-yearly, annual or cumulative as per the discretion of the investor. The cumulative option is the best since the interest gets reinvested and earns money for the investor. However, the choice rests with the investor and would depend on his investment objective.
Why invest in Non-Convertible Debentures?
Better returns: Generally NCDs offer high returns and lower risks. Investors are known to make up to 8 percent returns after taxes. However, the actual rate of return would depend on the interest being offered, which in turn is influenced by the market scenario. In the eventuality that funds are scarce and funding is difficult, companies tend to offer a higher rate of interest and vice versa.
Not subject to TDS: Unlike interest income from FDs being subject to TDS, interest received from NCDs are not subject to TDS under section 193 of the Income Tax Act.
Easy liquidity: Some NCDs come with built in “PUT Options” which allow for a premature exit in return for the face value on the stipulated date. Also, the listing of NCDs on the stock exchange allows for greater liquidity.
Risks associated with Non-Convertible Debentures
The primary risk associated with Non-Convertible Debentures is the probability of the value falling below the face value. Another risk is the Interest rate risk in the secondary market due to a premature exit. These risks can be overcome by holding on to the NCD until it attains maturity.
NCD Vs FD/Corporate FD
1). Unlike FDs, NCDs are traded on the exchange and hence more liquid thereby enabling the investors to exit even before the maturity.
2). Most NCDs are secured in nature which are backed by the assets of the company, unlike FDs, though Bank FDs are backed by insurance for a maximum of Rs. 1 lakh.
3). There is no TDS on the interest income of the NCDs. Whereas, TDS is applicable in case of Bank deposits.
What kind of investors should invest in Non-Convertible Debentures?
Having talked about NCDs and their risks as well as benefits, let us now talk about the typical investor who would benefit from investing in this debt instrument.The typical investor who wishes to make a stable and consistent return with the least risk is an ideal candidate to invest in NCDs. Yet another class of investors who are looking at diversifying their portfolio while continuing to enjoy the security of a fixed income should also consider investing in NCDs. Fixed Deposit Investors can consider investing in NCDs to improvise their returns.
Regardless of all considerations, it is the risk profile and investment objectives of the individual which determines the investment portfolio. The decision to invest must be made only after carefully considering individual risk appetite which would vary from person to person and as per individual circumstances.