First let’s understand what is a convertible debenture is. A convertible debenture is a special type of bond that allows holder to change it to equity after a predetermined time. Since this is a bond, it pays you interest rate. Once you convert it to equity, the interest rate is not paid. Instead, you get your returns by dividend if company declares it and price appreciation of equity.
A non-convertible debenture (NCD) is a bond that cannot be converted into equity. Since the convertible debentures can be converted into equity, it offers low interest rate compared to non-convertible debentures that offers higher interest rate.
NCDs can be secured or unsecured. The secured NCDs are backed by assets of the company. In any eventuality when the company is not able to meet its obligation, its assets can be sold to pay off to the bond holders. Unsecured debentures are not backed by any asset. So why would someone invest in NCD. The reason is that they offer better returns.
NCD – The new wave
Recently, the market has been flooded by NCDs by various companies. The inflation is high and bank deposit is giving negative returns in real term. At the same time equity has become very risky because of volatility in the market in last couple of months. Even all-weather friendly Gold is skyrocketing.
Sensing the opportunity, companies have come up with NCDs with different variants to attract investors. The other reason is high interest rate charged by banks on loan.
NCDs are low to medium risk depending upon the company that is floating them. This is pretty well suited to investors who do not want to take much risk with their investment. This also offers a much better returns that bank FD and many Government securities.
For example, Shriram City Union offers 11.85% to 12.10% interest on the NCD it floated. The minimum sum required to invest in this is Rs. 10,000. The maturity is anywhere between 3 to 5 years. Rating assigned by CRISIL is AA- which means stable.
There are similar NCDs in the market by Muthoot Finance, Tata Steel, Mannapuram, and many more. Investors are requested to go through their rating, interest rate, past history, and company’s reputation.
NCDs – the product
The tenure of NCDs can be anywhere between 2 years and 20 years. This gives enough flexibility to investors. Moreover, unlike FDs, you do not have to lock your capital for e certain period of time.
NCDs are available in the market and hence trading is not a problem. You can dispose of or buy whenever you want. You may face some liquidity issue for the NCDs which are not highly rated and have not been doing well.
Capital gain tax on NCD is simple. If you sell your debentures before a year, you will have to pay taxes at the same % you fall into. If the debenture is sold after a year, you will pay tax of 10%, if indexation is not done, or 20% if the indexation is done.
Points to keep in mind
The return of NCDs may not be attractive when interest rates are high.
NCDs are relatively safer assets than equity and mutual funds but they are riskier than bank FDs and Government bonds. Banks and Government do not default on their obligation. RBI always comes to help banks in emergency cases and Government prints money to fulfil its obligation in emergency situation. NCDs normally do not default but when things go drastically wrong, they may face problem in paying the investors.
Investors do not find NCDs exciting like equity and mutual funds and hence the number of transactions may be less. This may cause liquidity problem when investors want to sell off. The investor may have to sell at a low price because of low liquidity. This again depends on case to case basis. There are NCDs by stable companies which are pretty liquid.
NCDs are rated by rating agencies such as CRISIL. Investor must take a look at the rating and understand what they mean before they invest in them. Investors should also check the company’s records in meeting its obligation.
Do not invest more than 20% of your investment in NCDs. You should allocate your funds in various instruments such as equity, mutual funds, debt, and money market.
The author Pankaj Priyadarshi is a financial consultant and can be reached at email@example.com. He is B.Tech from IIT, Kharagpur and MBA from ISB, Hyderabad.