Company FDs are issued by finance companies, HFCs and other NBFCs and provide better returns. However, there are a few things to consider before you put your money in them.
Among the various investment options available for an investor, the most popular are the bank deposits and mutual funds. At one point when interest rates were much higher, company FDs were an attractive investment avenue. With rates coming down, most investors did not seem much merit in investing in company FDs. Of course, the rates of interest were higher than bank FDs and if you went for mid-cap companies, then FD rates were still higher. But that came at a cost; because these higher rates came with a higher default risk. Let us look at these company deposits in greater detail.
Understanding Company fixed deposits (CFD) as an investment avenue
CFD is a type of Fixed Deposit which is issued by companies. Normally, such CFDs are issued by finance companies, housing finance companies and other NBFCs as they have limited access to bank and institutional funding. For the purpose of safety, these CFDs are generally rated for their capacity to service interest and principal by the rating agencies such as ICRA, CARE and CRISIL and there are more like Fitch, India Ratings etc. Remember, that these CFDs are unsecured and it is like an unsecured loan that you are giving to the company. The only sense of comfort that you have is the quality of the company that you are investing into and its pedigree and reputation in the market. We have seen in the past that investing in CFDs of reputed companies may imply lower returns but they are very safe.
Here are 5 things you should know before you invest in a company fixed deposit (CFD).
1. Company FDs pay higher rates but come with a higher default risk
A company Fixed Deposit pays a higher interest rate compared to banks and other government savings schemes. For example, a typical CFD by a reputed company would pay you around 9-9.5% interest per annum. These CFDs come with a variety of interest periodicity options like monthly, quarterly, half-yearly, and yearly option. Thus, you can structure the deposit investment according to your cash flow needs and the period you are willing to lock in your investments. However, don’t choose a CFD only based on interest rates but also look at the quality of the company, its reputation and the promoter group.
2. All CFDs have to be necessarily credit rated
For a CFD issue, a credit rating by an authorized rating agency is mandatory. These ratings give you an idea about the credit worthiness of the company and gauge its ability to service the interest payments and the principal payments. As an investor, you can use the assigned credit rating score as a starting point to decide on your investment in company FDs.
3. CFD carries risk of default and risk of liquidity
What do we understand by default risk here? CFDs have default risk where the company may not be able to service the interest and principal due to weak business environment. Also, if there is a rush to withdraw the deposit, then the company could get into a cash crunch and may default on the CFDs. As an investor you need to be aware that there is a penalty on premature withdrawal of CFDs. Such penalties range from 5% to 10% of the outstanding amount and come with a lot of strictures. This substantially reduces the liquidity of these FDs. Also, such FDs are not listed on any stock exchange (unlike debentures and bonds), so there is no secondary market exit route for the investor.
4. In post tax terms, the CFD scores lower than other avenues
The company fixed deposits may appear tempting because of their high interest. But, you need to look at returns in post tax terms and not in pre tax terms. If you fall in the 30% tax bracket, the interest that is earned on your company FDs will be subject to tax at 30% plus the surcharge and cess as applicable. An interest rate of 9% on CFDs will be less than 6.3% in post-tax terms, which largely takes away the attractiveness of the instrument. You need to remember that CFDs can be very tax-inefficient. Hence, you can enjoy no tax benefits.
5. Read the fine print before investing in the CFD
When you apply to invest in a company FD, you will be given an application form to fill in and sign. Make it a point to read the fine print. The print will actually be very fine but it is worthwhile going through it. Know the financials of the company, the directors of the company and how the CFDs will rank with other debtors in the event of liquidation. These are important information factors for you. If you have any doubts about any clause, check with your tax consultant or your financial advisor. Of course, don’t forget to appoint a nominee for the company FDs. This is beneficial for the investor as life is unpredictable and should something happen to the investor before the FD matures, the money will be given to the nominee without any legal hassles.
Remember two important things before putting money into the company fixed deposit. Remember it is an unsecured instrument and you have no control on how the company uses the funds. Secondly, ensure that this CFD investment is within the contours of your overall financial plan.
(By Vaibhav Agrawal, Head of Research and ARQ, Angel Broking)