This article talks about Non-Convertible Debentures (NCDs), which are fixed-income instruments for specific terms and interest rates.
When it comes to raising funds by a company, equity and debentures are the two most common ways. While equity shares of a company provide investors with ownership of the company, debentures are an acknowledgment of debt obligations towards the company. Some debentures may have the feature of convertibility into shares at the discretion of the investor after a certain period, while other debentures do not carry such options. The former type of debentures is called Convertible debentures, while the latter one is non-convertible debentures (NCDs).
Non-Convertible Debentures (NCDs)
NCDs are widely used tools to raise long-term funds by companies through a public issue. NCDs are fixed-income financial instruments having fixed tenure and interest rates. As NCDs do not possess the option of convertibility, investors are compensated through higher rates of return as compared to convertible debentures. The interest is paid out to investors either monthly, quarterly or annually depending upon the terms of the issue. Generally, NCDs are not backed by collaterals, and thus the reputation, creditworthiness, and credit rating of the issuer company becomes very significant for the investor. NCDs benefit investors through their high returns, low risk, high liquidity, and tax benefits.
Features of Non-Convertible Debentures
- High-Interest Rate: Debentures provide a fixed interest rate which is commonly known as coupon rates. NCDs generally offer higher interest to the investors, specifically in cases of unsecured NCDs. Usually, the coupon rates offered by NCDs vary between 7-9% p.a. The interest rates on NCDs are inversely proportional to the creditworthiness of the company as returns increase with risk.
- Maturity Period: The tenure of NCDs is fixed at the time of issue. The minimum maturity period is 90 days and can be 10 years or even 30 years.
- Tradability & Liquidity: Normally, NCDs are listed on stock exchanges and hence can be traded in the secondary market. This makes NCDs highly liquid securities.
- Subscription Mode: Investors can either subscribe to NCDs directly through public issues or buy these securities from the secondary market (stock exchanges) through a registered broker.
- Credit Ratings: In India, credit rating agencies such as CRISIL, CARE, etc. give ratings to the company raising funds through debentures. Higher credit ratings mean that the company has the ability to honor its debt obligations, whereas a low credit rating means that the company has a high credit risk involved. Thus, investors should always check the credit rating of the debentures and the issuing company before investing in them.
- Taxation: The tax burden of NCDs depends on the tax slab rate that investors fall under. The interest income on NCDs is taxed under ‘ income from other sources ‘ at the specific slab rate of the investor. If investors sell their NCDs before 1 year, STCG is applicable on gains as per the tax slab rate of the investor. If NCDs are sold after 1 year, LTCG is applicable at the rate of 20% with indexation benefits.
Types of Non-Convertible Debentures
NCDs are classified mainly under 2 categories i.e., secured, and unsecured debentures:
- Secured NCDs: The nature of the debentures is set at the time of their issue. Secured NCDs are backed by any kind of collateral or assets by the company. In the event of default by the issuing company in repaying the redemption amount, the collateral or asset of the company is liquidated. As these securities carry less risk, the rate of interest offered by them is lower as compared to unsecured debentures.
- Unsecured Debentures: Unsecured NCDs are not backed by any kind of collateral or assets by the company. In the event of default by the issuing company, investors have no choice but to wait for repayments. This type of security is riskier in nature and thus carries a higher rate of interest. It is highly advised to investors to only invest in such securities that are issued by high credit-rated companies.
How to Invest in Non-Convertible Debentures?
Investors can invest in NCDs in 2 ways:
- Public Issue: NCDs are primarily issued by companies through public issues for a specified period of time. Any investor can purchase these debentures within this stipulated period by following the same procedure as in the case of an IPO issue of share of any company. Investors can apply for NCDs through their brokers and based on the subscription, investors are allotted a respective number of NCD units. On allotment, NCD gets credited in the investor’s Demat account and the money is deducted from their trading or bank account.
- Secondary Market: NCDs are traded on stock exchanges after their public issue. Investors can purchase NCDs through stock exchanges with the help of their Demat account or brokers, in the same manner as they buy shares of any company.
Factors to be considered by investors before investing in NCDs
Generally. NCDs are not secured and are only backed by the creditworthiness and debt servicing capability of a company. NCDs are highly vulnerable to business risk, credit risk, and other threats. Thus, investors should consider the following factors before investing in any NCDs:
- Reputation & Credit Rating of the issuing company: As NCDs do not give any option, it is highly dependent on the repayment capacity of the issuing company. For this reason, the reputation and credit rating of the issuing company plays a significant role while investing in NCDs. It is highly recommended to investors to choose NCDs of companies with an AA or higher credit rating.
- Debt-Equity Ratio: It is the ratio of the debt to equity in a company. It measures the extent to which the company is financed by debt as compared to equity. The company should not depend heavily on debt. A debt-equity ratio higher than 2:1 is considered unhealthy for the company.
- Capital Adequacy Ratio (CAR): The CAR ratio measures the capital of a company against any potential losses. It depicts whether the company has sufficient funds to survive potential losses or not. Investors must ensure that the company they plan to invest in has at least a 15% CAR.
- Interest Coverage Ratio: This ratio depicts the number of times the interest is covered by the earnings of the company. It ensures that the company can meet its periodic interest obligations. A higher interest coverage ratio is considered a healthy sign for the company.
- Adequate provision for NPA: A healthy company should provide for at least 50% of its potential Non-performing Assets (NPA). This ensures that the company can generate enough revenues to meet its obligations and thus can mitigate the risk that investors face.
Summary
NCDs are attractive financial investment options offering high-interest rates for a fixed tenure. But investors should not completely rely on interest rates for investment. It is significant from an investor’s point of view to properly examine the credit rating of the company, and other relevant financial ratios of the company to ensure that the investment made is safe and secure with minimal risk of default.