Investing in Non-Convertible Debentures- All you need to know
It’s said that earning money is difficult but one would also agree that it’s equally difficult to invest hard-earned money in the right avenues for making good returns that too with safety! Investments should always be diversified to balance the risk associated with investing.
Investors keep on researching for fixed income investments with healthy returns. Are you also looking for the same? Well then, Non-Convertible debentures (NCDs) are one such type of investment that gives a higher rate of return when compared to other fixed-rate investments like Bank FD. That appears attractive, so let’s discuss the features and benefits of NCDs.
NCDs are types of debt instruments issued by the company to raise long-term finance. NCDs have a fixed tenor and interest is paid to the investors either monthly, quarterly, or annually depending on the tenor specified.
Individuals, banking companies, primary dealers other corporate bodies registered or incorporated in India, and unincorporated bodies can hold an investment in NCDs.
An investor who always looks for an investment option that manages liquidity risk offers significant returns and suits his financial goals shall look to invest in NCDs. Investment in NCDs results in diversification of portfolio with income security.
Ratings of the Company / NCDs– An investor should consider the rating of the company issuing NCDs. Issuers who have higher ratings are preferable however it should be kept in mind high rated companies offer less return of interest as compared to companies with lower ratings. Hence investors can choose between the two depending on their risk appetite. However, investors shall not go beyond a particular rating grade as it may be too risky to invest in such NCDs.
Taxation– Interest on NCDs is taxed as per the slab rates applicable to the investor. If an investor falls in the higher tax bracket like 30%, interest will also be taxed at 30%. Further, if listed NCDs are sold within a year or less STCG will be applicable as per the income tax slab rate. If the listed NCDs are sold after a year or more or before the maturity date, it would attract LTCG.
The debt level of the issuer and Interest coverage ratio of the issuer– While investing, an investor should check the debt levels of the company and the allocation of debt to its capital. One should also refer to the Interest coverage ratio which highlights the regularity of the company to service the interest payments on its debt.
An investor shall understand the difference between XIRR (extended internal rate of return) and coupon rate of returns. Usually, XIRR is higher than the coupon rate and investors shall always compare XIRR of different options of NCDs. Generally, XIRR is greater if the cash flows are more regular. Let’s understand this with help of an example.
Let’s say Company X is offering an NCD for coupons of 10% with monthly interest payouts and Company Y is also offering NCD for the same coupon rate i.e 10% but interest payout is on a quarterly basis. Now in this example, XIRR from NCD of Company X would be 10.47% and XIRR of Company Y NCD would be 10.30%. This shows that Returns from Company Y are higher as compared to Company X. Though in this example there is a slight difference but if the time period is greater, the difference could be higher.
NCDs can either be secured or unsecured. Secured NCDs are secured by way of the creation of charge on the assets of the company. The charge has a value equal to the value for the repayment of the debenture and interest thereon. In case of non-payment by the issuer, debenture holders can claim the value through the liquidation process. Unsecured debentures on the other hand do not have any charge on the assets of the company issuing NCDs. Thus, they are riskier and carry a higher rate of return than the Secured NCDs.
NCDs are issued by public companies and also by way of private placement by limited companies. However, bonds are issued by large public companies, governments, and financial institutions. Bonds are generally secured but NCDs can be both, secured or unsecured. During liquidation, bondholders are given first priority for repayment and then to debenture holders.
Companies generally issue NCDs for the long term but some companies can also issue them for less than a year if it fulfills the below criteria laid by RBI:
1. Having a tangible net worth as per the latest audited balance sheet, of not less than Rs.4 crore;
2. The company has been sanctioned working capital limit by bank/s or all-India financial institution/s;
3. The borrower’s account of the company is classified as a Standard Asset by the financing bank/s/ institution/s.
4. Rating Requirement- An eligible corporate is required to obtain a credit rating from any of the credit rating agencies like CRISIL, ICRA, CARE, FITCH, or any other rating agency as specified by RBI from time to time for issuance of NCDs. The issuers shall ensure at the time of issuance of NCDs that the rating so obtained is current and has not fallen due for review.
A company issues NCDs to raise long term capital to achieve its business goals like
To refinance its existing debt
To expand its business operations and other corporate purposes.
There can be two ways of issuing NCDs
Public Issue-NCD public Issue is the issue of a redeemable corporate bond; a bond issued by a company to raise money from the capital market. Unlike equity shares, bondholders do not have any ownership interest in the company. They are usually issued by high-rated companies in the form of a public issue to accumulate long-term capital. They offer relatively higher interest rates when compared to convertible debentures.
Private Placement– Private Placement in simple terms is the sale of shares or bonds by a corporate to pre-chosen investors/institutions rather than an offer to the public. The company has to follow guidelines for Private placement of NCDs as laid out under the Companies Act 2013. Approval of the Board is required for the issue of NCD and deciding its terms of issue. PAS-4 (Private Placement Offer cum Application Letter) form requires approval in the Board meeting. Appointment of Debenture Trustee and a separate bank account needs to be opened for subscription number receipt.