Non- convertible debentures have been in existence for quite some time and although a majority of retail investors are fairly familiar with the subject, their popularity as an alternate savings avenue is not very high due to the lack of complete understanding and the features associated with these instruments. With interest rates on bank fixed deposits at all- time lows, it could be a good time to take a look at some of the benefits offered by NCD’s.
To begin with, let’s first understand the definition of a debenture, who issues them, risk factors, tax liabilities and then go on to see how they serve as a savings alternative compared to time or fixed deposits with banks.
A debenture is a fixed income or debt instrument issued by a company, firm or corporate entity looking to raise capital from the general public. These debentures earn a fixed rate of interest and on maturity, the interest along the principal is returned to the investor.
There are three types of debentures currently offered
1) Convertible debentures- Can be converted into common equity shares of the issuing company after a certain period.
2) Partially convertible debentures- Part of the debentures can be converted into common equity shares after a certain holding period and the rest redeemed on maturity.
3) Non- convertible debentures- Cannot be converted into equity shares of the issuing company and have to be redeemed on maturity.
As long as you are a holder of the debenture, the issuer continues to pay a fixed sum of interest. However, once a debenture is converted to common equity shares of the issuing company, interest payments will be withdrawn by the issuer and the return on investment will entirely depend on the performance of the equity shares of the listed company.
Highlighted below are some of the key features and risks associated with investing in non- convertible debentures
1) Non-Convertible Debentures (NCDs) issued through an IPO are governed by SEBI (Issue and Listing of Debt Securities) Regulations, 2008
2) NCB’s issued in India have to be rated by a credit rating agency such as Crisil, Fitch, ICRA etc. The ratings generally indicate the level of risk associated with the debenture.
3) Interest offered by these debt instruments are usually based on the credit rating. Normally higher rated NCD’s are low risk instruments and typically pay lesser interest compared to those with a lower credit rating.
4) Secured NCD’s are backed by the assets of the company issuing them and in the event of a default, the assets are liquidated to pay off investors.
5) Unsecured NCD’s are not backed by assets of the issuing company and in the event of a financial crunch, the risk is borne by investors.
6) NCD’s are listed on stock exchanges, thereby offering an alternate platform for investors to exit before maturity.
7) They behave exactly like any other debt instrument and are in demand during a falling interest rate regime.
8) Interest earned from NCD’s is summed with the total income and taxed at the marginal tax rate of an individual.
9) NCD’s are subject to interest rate risk, credit risk and although they are listed on the stock exchanges, there is also a high p
robability of liquidity risk.
Interest earned on NCD’s are generally higher than bank FD’s. Although these instruments carry a greater risk compared to the extremely low risk that comes with bank deposits, investors can mitigate their risks by choosing secured NCD’s of listed blue- chip companies. In addition, NCD’s have terms ranging from 90 days to 20 years, giving investors the option to save both for the short and long term compared to the maximum 5- year term offered by bank deposits. Also, the frequency of interest payments by NCD’s vary from monthly, quarterly, annually to interest on maturity, giving investors the option to choose how they wish to receive their interest income. In the event of interest rates on bank FD’s rising more than the NCD’s, investors can sell their NCD’s in the secondary markets and invest the proceeds in the low risk FD’s to earn higher income.
To conclude, investing in NCD’s are completely based on the risk attitude of investors. However, a secured NCD with a higher interest rate differential to a bank deposit is worth the small risk. Investors are advised to go through the offer document of the issuer before investing.