High-risk affair

Written by Saikat Neogi | Updated: Jul 31 2012, 09:16am hrs
While non-convertible debentures offer good returns, they carry higher default risks than bank or postal deposits and are not very liquid

With the equity market remaining range-bound for the past one year and debt products offering near double-digit rates, non-convertible debentures (NCDs) seem to be back in favour. Shriram Transport Finance Company (STFCL), a Chennai-based non-banking financial company, has floated a public issue of NCDs, which is open till August 10.

The company plans to raise R300 crore with an option to retain over-subscription up to R300 crore. The minimum investment is R10,000 and in multiples of R1,000 and the face value of each NCD is R1,000. The company will pay interest up to 11.4% per annum for a 60-month tenure (the coupon is 10.5% plus 0.90% for individuals). For a 36-month tenure, the coupon for individuals will be 11.15%. The company is providing two options annual and cumulative and a demat account is not mandatory for retail investor to invest.

There will be no tax deduction at source (TDS) on interest if the NCDs are held in demat form as is the rule on any security issued by a company in a demat form and is listed on recognised stock exchange in India as per the Securities Contracts (Regulation) Act, 1956. Moreover, there will be no TDS if the interest does not exceed R5,000 during the financial year and the interest is paid by an account payee cheque.

Analysts say one should invest in NCDs only if he can hold them till maturity. If NCDs are sold on the stock exchange within 12 months from the date of allotment, short-term capital gains/losses (STCG) will arise. But beyond that period, it will be treated as long-term gains/losses. While STCG would be taxed at normal rates, LTCG on sale of NCDs on the stock exchange is always taxable at 10.30% (including education cess of 3%) without indexation. The STFCL issue is rated Crisil AA/Stable by Crisil and CARE AA+ by Care. These ratings indicate high degree of safety regarding timely servicing of financial obligations and carry low credit risk. Being a non-banking finance company, STFCL is primarily involved in borrowing and lending and operates mostly in financing of pre-owned commercial vehicles.

The interest rate offered STFCL is about 200-500 basis points more than what bank are offering for fixed deposits. Since NCDs are compulsorily rated by at least one approved rating agency, they provide some extra comfort to investors and they are also listed on the stock exchange. Companies issuing NCDs offer higher rates because they carry much more default risk compared to bank or postal deposits. Unlike bank deposits, NCDs are not insured against any default and come with longer tenure.

Analysts say though the interest rate is lucrative for a retail investor, NCDs are not as liquid as bank fixed deposits as the secondary market for corporate bond is not that well developed in India. Which means, without a vibrant secondary market for these bonds, an investor may have to sell at a discount.

Typically, NCDs cannot be converted into equity or preference shares and come with a higher rate of interest. After maturity or redemption, the company gets back its debenture and the debenture holder the principal invested, along with the interest accrued. The listed debentures are treated as long-term capital assets if the NCDs are held for a period of 12 months.

For STFCL, one of the major risks is the volatility in interest rates and the company is substantially dependent on net interest margins. The company borrows funds on both fixed and floating rates and lends to customers predominantly at fixed interest rates. The company has underlined in the draft red herring prospectus that volatility in interest rates can materially and adversely affect the financial performance and cash flows.

In a rising interest rate environment, if the yield on our interest-earning assets does not increase simultaneously with or to the same extent as our cost of funds, or, in a declining interest rate environment, if our cost of funds does not decline simultaneously or to the same extent as the yield on our interest-earning assets, our net interest income and net interest margin would be adversely impacted, it says.

Also, additional risks arising from increasing interest rates could result in the extension of loan maturities and higher monthly instalments due from borrowers, which, in turn, could result in higher rates of default. Moreover, reductions in the volume of commercial vehicle loans could effect the company's earnings. The company requires substantial capital, and any disruption in funding sources would have an adverse effect on liquidity and cashflows. Also, the company says that a large part of its collections are in cash and, consequently, faces the risk of misappropriation or fraud by our employees.

Analysts say within an investors' overall debt allocation, it is preferable not to invest more than 25% in company fixed deposits or NCDs, given their higher risk profile and poor liquidity compared to bank deposits and debt mutual funds. They also advise not to invest over 5% of one's portfolio in companies which offer abnormally high yields.

NCDs decoded

* If NCDs are sold on the stock exchange within 12 months from the date of allotment, short-term capital gains/losses (STCG) will arise

* Beyond that period, it will be treated as long-term gains/losses

* Unlike bank deposits, NCDs are not insured against any default and come with longer tenure.

* NCDs are not as liquid as bank fixed deposits as the secondary market for corporate bond is not that well developed in India

* NCDs cannot be converted into equity or preference shares and come with a higher rate of interest

* Within an investors' overall debt allocation, it is preferable not to invest more than 25% in company fixed deposits or NCDs

* It is advisable not to invest over 5% of one's portfolio in companies that offer abnormally high yields