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Beginners guide on investing in NCDs

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A complete guide for beginners on investing in Non-convertible debentures NCDs

Do you still invest your hard-earned money in fixed deposits (FD), postal savings, and similar investments just because they are safe despite knowing the fact that they offer low-interest rates along with no liquidity? In other words, Are you fed up with receiving low returns on FD and looking for better investment opportunities with balanced risk & return profiles along with good liquidity? Well, gone are the days of limited investment opportunities and currently, there are many investment avenues that are not just safe option but also offers a comparatively higher rate of return than FDs. Non-convertible debentures (NCDs) is one of the top choices among investors who are looking for a better-fixed return of 9% - 10% per annum at low risk and prefer high liquidity.

Do you want to know more about investing in NCDs, the article is for you to provide a complete review of meaning of NCDs, types of NCDs (Secured and unsecured), NCDs expected returns, how to invest in NCDs, and more.

What are Debentures?

Debentures can be defined as long-term financial instruments that are issued by a company for a specified period of time along with a promise to pay a fixed interest or coupon rate to the investor. Debentures have a towering presence in the Indian Financial system. Debentures are considered the best investment option for investors who want the following features;

  • Good liquidity
  • Managed risk.
  • Higher returns than FDs.

Depending on the convertibility feature, debentures are of two types, namely convertible debentures and non-convertible debentures (NCDs). Former can be converted into shares based on the owner’s discretion whereas NCDs cannot be converted into shares.

What are Non-Convertible Debentures (NCDs)?

Non-Convertible debentures, as the name itself, are those debentures that can't be converted into shares in the future at the owner’s discretion and have to be repaid after a fixed period of time. As such debentures don’t have convertibility features, therefore, lenders or issuers generally pay a higher rate of return than convertible debentures.

Characteristics of Non-Convertible Debentures

  1. A non-convertible debenture is a debt component or debt instrument.
  2. It cannot be converted into shares or equities.
  3. NCDs have a fixed maturity date.
  4. Interest rate also called coupon rate is pre-determined or pre-fixed in non-convertible debentures.
  5. Interest on NCDs can be paid either monthly, quarterly, bi-annually, or annually.
  6. Non-Convertible debentures are traded on the stock market.
  7. Companies with good credit ratings can issue NCDs.

Types of NCDs| Secured and Unsecured NCDs

NCDs can further be divided into secured NCDs and unsecured NCDs.

  • A secured NCD is supported/backed by the company’s assets like land, buildings, or machinery. If a company fails to meet debt obligations then the investor has the right to claim for asset liquidation, therefore, considered a safe instrument.
  • Contrarily, an unsecured NCD is not backed by issuing company’s assets. Consequently, a company would pay a higher rate of return for an unsecured NCD than a secured NCD.

List of current NCDs in India

Advantages of Non-Convertible Debentures

When compared to Convertible debentures, NCDs are lucrative and attractive investments and in essence, are considered superior investments as they offer

  • Supreme returns within the range of 7% to 9% if held till maturity.
  • Liquidity as they are listed on Stock Exchange and tradeable instrument.
  • Low risk as they are debt instruments.
  • Tax benefits when they are compared to that of convertible debentures.

Things you must know before investing in NCDs

Important to mention is that before investing in NCD, you should check

  • Company’s credit rating: Generally, you would be on the safer side if you purchase NCDs with a higher rating. Companies which are having good credit ratings (i.e., CRISIL AAA or AA) mean lower default risk and the firm is able to service its debt obligations timely. Contrarily, a low credit rating means that the company has high credit risks. So, If any of the issuing companies fail to make payments then the rating agencies accord them a lesser ranking.
  • Interest Coverage Ratio: The Interest Coverage Ratio indicates the firm's ability to comfortably pay the interest due on its loans and debentures at any given time. It assures that the company has the ability to handle possible evasions.
  • Capital Adequacy Ratio (CAR): CAR measures the magnitude of the company’s capital and verifies if the company has the availability of sufficient funds to survive in case of potential losses. An ideal CAR is 15%.
  • Level of Debt: Do not invest in the NCDs if the company apportions more than 50% of its total assets towards unsecured loans.
  • Always remember that Organizations/companies resort to raising funds using NCDs to meet a specific business purpose. So, Read the terms and conditions carefully. If the picture looks cloudy do not invest.
  • Diversification of NCD: NCDs from one single sector is not safe to invest in. So diversify investment in NCD.
  • Never be impressed by only the higher interest rate of NCD. Instead, search for other indicators (of financial health) of the company also. For Instance, if the NCD’s yield (that decides your real returns) is low. Investment in NCD would be a dead investment.

Yield can be defined by an example. If the interest is paid out annually, then the effective yield (on an annual basis) is the same as the coupon rate. If the coupon amount of 12.5% is paid out at monthly intervals, then that will raise the effective yield in the above example to, say, 13.25%. The reason is, you get the amount of money every month and it is assumed that you will be able to reinvest that money at the rate of 12.5% per annum, thereafter.

NCDs Tax implications

NCDs are not tax-exempted securities as they do carry tax implications depending upon the investor’s tax bracket. If an investor sells NCDs within one year then short-term capital gain (STCG) tax will be applicable as per the slab rate however if it is sold after a year but before the maturity period then long-term capital gain (LTCG) tax at 20% tax rate with indexation benefit will be applied.

If an investor held NCD till the maturity period then the capital gain will be taxed as per the income tax slab that the investor falls into. Interest received on NCDs is also taxed similarly under the head “ Income from other sources”. Henceforth, an investor must consider post-tax NCD return to decide whether to subscribe to an NCD or not.

Final Remark

Before putting your money in any avenue, it is advisable to must keep a check on your risk appetite, return expectations, NCDs coupon rate, issuer credibility, and credit rating as well. On a return & risk basis, NCDs can be the best investment option for typical investors who want stable & consistent returns with managed risk. Thus, FD investors can consider NCDs as an ideal alternative to get higher returns.

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FAQs

Yes. An Individual can buy and sell the NCD online just like shares in Demat form. For Instance, an investor (based in Mumbai) by using the terminal (software) of BSE can sell (within a fraction of a second)the NCD to another person sitting in Kolkatta in a dematerialized form. The digital form of NCD (just like digital money) is a method of buying and selling NCD’s online.

 

No, NCDs neither fall in the category of shares nor fall in the category of bonds. They are a distinct entities.

 

NCDs can be bought in the primary market as a part of a public issue or they can be bought and sold in the Secondary Market.

In the first case, an individual has to apply for an Initial Public Offer by filling out an online form or via the Application Supported by Blocked Amount (ASBA) route. The method blocks the application amount in your bank account and it keeps earning interest, once allotment is finalized and you have been allotted with NCDs then only the amount will get debited from your bank account, and the NCD will be transferred into your Demat account.

In the case of the secondary market, an investor can purchase and sell NCDs online from the stock exchange through your Demat account.

 

Yes, NCDs can be sold before maturity and they can again be traded on Stock Exchange. Interest on NCD would be paid to that person who holds NCD on the date of payment of interest.

 

Generally speaking, A Demat account is required to buy or sell NCDs because the debentures allotted will be transferred to your Demat account. Most NCD issuers prefer issuing NCDs in the Demat mode only.

 

For Residents Indians holding NCD in Physical form, Income Tax is deductible at source on interest on debentures as per provisions of Section 193 of the Income Tax Act, 1961. However, no income tax is deductible under section 193 in the case of residents where such debentures are in dematerialized form and is listed on a recognized stock exchange.

For Senior Citizens holding NCD whether in physical form or in Demat, no Income Tax is deductible at source on interest on debentures.

In all other cases, tax shall be levied for interest on debentures.

 

Yes Foreign Institutional Investors are allowed to invest in NCDs. However, it shall be treated as capital gain and accordingly interest shall be levied on FIIs. However, Investments by the FIIs shall be within the limits as may be mentioned in this regard from time to time by the SEBI.

 

NCDs may mature from short-term to long-term tenure, varies from a minimum time period of 90 days to a maximum period of 20 years.

 

Bonds are backed by government guarantee whereas the same is not necessary in case of NCDs. But generally speaking, NCDs are also secured to a larger extent if not 100%. However, bonds carry a lower rate of interest as compared to NCBs.

  • In case of highly rated company, NCD can be issued by both the Government company or any other public listed company while bonds are backed by the Government's guarantee.
  • NCDs have comparatively higher rate of interest (return, coupon rate) than Bonds.
  • NCDs cannot be converted into shares whereas convertible bonds are convertible into shares.

 

NCDs can be issued to the following;

  1. individuals, banks, Primary Dealers (PDs), other corporate bodies including insurance companies and mutual funds registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs).
  2. Investments in NCDs by Banks/PDs shall be subject to approval of the concerned regulators.
  3. Investments by the FIIs shall be within the limits as has been set forth by the SEBI.

 

Yes. NRIs can invest in NCDs subject to the condition that Issuer Company allows NRIs to do so. They can purchase NCDs on repatriable or non-repatriable basis however NRIs based in USA, domiciled in USA, resident or citizen of USA, and subject to any taxation law of USA are not eligible to invest in NCDs.

 


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