With the recent stir created by the DHFL Non-Convertible Debentures (NCD) issue being oversubscribed by 6.33 times, fixed income investors seem to be eyeing NCDs as the next shiny object.
For those who are still wondering what an NCD is, here’s a gist of the concept. An NCD is almost like a fixed deposit offered by a company (as against a bank).
A debenture is a type of debt instrument which offers a fixed rate of interest for a specified tenure. Simply put, debentures are loans taken by the companies from the general public. A debenture can be classified as either convertible or non-convertible. A convertible debenture can convert into an equity share of the company, thus giving it rights to participate in the company’s profit. However, such debentures usually yield lower interest rates. NCDs on the other hand, do not have the option to convert into equity and hence, yield relatively higher interest rates.
NCDs typically have a credit rating to reflect the expected credit performance of the company. Secured NCDs are further protected by assets collateralized. Usually, companies that have a lower credit rating offer higher interest on the NCD. Often, issuers offer a higher interest rate to the company’s shareholders or senior citizens.
Tax implications on NCDs are same as Bank Fixed Deposits if held till maturity. Interest is taxed as ‘other income’ and charged at applicable tax rates. However, if you sell the NCD in the open market before maturity, the capital gains/loss will be taxable as per standard taxation for capital gains.
The following table illustrates the comparison between a 3 year SBI Fixed Deposit and 3 year DHFL NCD, considering annual payout and same initial investment for both.
|SBI Fixed Deposit||DHFL – NCD August’16|
|Amount Invested (Rs)||1,000||1,000|
|Period||3 years||3 years|
|Rate of Interest/Coupon p.a.||7%||9.20%|
|Annual Payout (Rs)||70||92|
The higher payout of the DHFL NCD simply reflects its higher risk compared to SBI.
Should you invest
Market interest rates are on the way down – for instance 10-year government bond yields have dropped almost 0.5 per cent points in the last 3 months. This means interest rates on fixed deposits and small savings could come down soon. In such a scenario, it is sensible to invest a portion of the short-term savings into NCDs and lock in a high interest rate. It is of course important to stick to highly rated companies or secured NCDs so that the risk is mitigated.
For longer term investments (i.e. >5 years horizon), equities or equity mutual funds continue to be the preferred options as they have a better chance of delivering higher returns and beating inflation. An NCD is most useful as a shorter term option to complement bank fixed deposits or liquid funds.
The author is Co–Founder, Fisdom.com