Non-convertible debentures: Four factors to consider when investing in NCDs

Published: August 16, 2019 12:11:18 AM

Investors need to consider aspects such as safety, liquidity, diversification and tenure of investment

NCDs present an attractive and tax-efficient route to invest, for conservative investors looking to get regular income with safety of capital. (Illustration: Shyam Kumar Prasad)NCDs present an attractive and tax-efficient route to invest, for conservative investors looking to get regular income with safety of capital. (Illustration: Shyam Kumar Prasad)

By Alok Agarwala

The IL&FS default in September last year exposed the fault lines in the Indian debt markets. As liquidity dried up, NBFCs and leveraged corporates running asset-liability mismatches found it difficult to refinance or rollover their short term debt and started defaulting on repayment obligations. This gave rise to risk aversion in the markets and credit spreads rose sharply. Credit markets were simply shut off to some sectors or groups.

This heightened risk aversion has given rise to opportunities in the market in the form of attractive non-convertible debenture (NCDs). Many corporates are trying to tap this opportunity. The RBI has been on a rate-cut spree and slowing growth concerns have driven the benchmark 10-year G-Sec yield down by almost 200 bps from its peak of 8.25% in October 2018. This has made the spreads on their NCDs look very attractive to investors. Some well-rated NCDs are offering yields as high as 200 to 300 bps above G-Secs and bank deposits of similar tenure, which makes these NCDs lucrative for a retail investor. Besides the higher coupons, NCDs enjoy some other advantages over bank deposits.

They are listed instruments and can also be sold before maturity, in secondary debt markets, without incurring the penal charges. Also, the gains on listed NCDs sold in secondary markets, are treated as capital gains. Capital gains on NCDs held for 12 months or more are treated as long term capital gains and taxed at 10.4% without any indexation benefit. This is much lower than the 31.2% tax charged on interest income to investors in the highest income slab.

Look before you leap
Investors need to exercise caution before investing in NCDs. Here are some factors to consider for investing in NCDs.

Safety: The financial health of the issuer, the reputation and financial strength of the promoter group, the strategic importance of the issuer to the promoter group and the support provided by the promoter group in terms of capital infusion and management support, the credit rating and the quality of corporate governance are some critical factors that need to be looked into before selecting an NCD for investment. Both secured and unsecured NCDs are available for investment. The investor must choose secured NCDs for investment for obvious reasons.

Liquidity: Liquidity plays a major role in investment decisions. Before investing one must check the liquidity situation of the issuer and its ability to repay debt in case of a stress event in markets. More importantly, the investor needs to check for liquidity in the NCDs / bonds of the issuer in the secondary markets. Lower rated issues from relatively small and less reputed corporates are generally illiquid. Hence, it makes sense to invest in reputed groups whose bonds / NCDs are traded frequently in secondary markets.

Diversification: Diversification is the most important risk management tool available to an investor. Investing all of your money in a single NCD can lead to huge losses if the issuer fails to repay on time. One must take care to diversify across issuers as well as sectors. For instance, one must not put a substantial chunk of investments in NCDs of housing finance companies as they are considered to be riskier in this environment. At a macro level, one must not invest more than 25% of their total debt portfolio in NCDs as a class. The remaining debt portfolio can be invested in debt mutual fund schemes, small savings schemes, etc., to diversify the risk.

Tenure: NCDs come with various tenures. The longer the tenure, the riskier it gets as one cannot say with certainty how the business will be in next 10 years. Economic and business cycles tend to change over such long periods. It is relatively easier to project the outlook for next three or five years. Moreover, the yields of longer term bonds are more sensitive to interest rate trends. Hence, one should ideally invest in three- or five- year NCDs only.

NCDs present an attractive and tax-efficient route to invest, for conservative investors looking to get regular income with safety of capital. Investors must select NCDs for investment judiciously to reduce risk and get optimal returns.

The writer is head, Research & Advisory, Bajaj Capital

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