'AA'-rated NCDs: Risky to focus just on returns, say analysts

Limit exposure to 5-15% of debt portfolio, avoid investing for very long tenures

Many players have launched ‘AA’-rated non-convertible debentures (NCDs) in recent times. These bonds promise higher rates of return than fixed deposits of frontline banks or ‘AAA’-rated bonds. Companies such as Indiabulls Housing Finance, Edelweiss Financial Services, JM Financial Services, IIFL Home Finance, IIFL Finance, Muthoottu Mini, and Indel Money have come out with such issues. 

Investors are likely to consider these instruments in the current low interest-rate environment. However, fixed-income investors face a dilemma. 

If they prioritise preservation of capital, they end up with low returns. And if they try to earn higher returns, they end up taking credit risk.

Beware of credit risk

These ‘AA’-rated issues come with higher risks. Some of them offer 9 per cent and above over the long term, others offer 7-9 per cent even over three years.

Do not decide on your investment based on returns alone. “The biggest risk in these offerings is credit or default risk. The investor may not get the interest, or even the principal, if the company defaults,” says Harshad Chetanwala, co-founder, MyWealthGrowth.com.

Pay heed to your liquidity needs

If you invest, be prepared to hold these NCDs until maturity. If you exit during the tenure of these instruments, you will have to sell them in the secondary market (on the stock exchanges), where they usually trade at a discount to fair value.

If there is turmoil in the credit market (caused by defaults, as had happened in 2018-2019), the secondary market for these bonds could disappear.

“There could be little liquidity in such bonds for investors who want to exit them in the interim period,” says Sandeep Bagla, chief executive officer, TRUST Mutual Fund. Hence, consider your cash flow needs before investing.

The tax factor

The interest payable on NCDs is taxable at slab rates. This makes them better suited for investors in the lower tax brackets. 

Those in the higher slabs would be better off investing in tax-free bonds or a debt fund, provided they are not looking for regular income.

“Tax-free bonds could be a viable option. Investment in mutual funds for more than three years can also be attractive after accounting for the low tax rates,” says Bagla. Capital gains on units of bond funds held for more than three years are taxed at 20 per cent post indexation.

Curtail your risks

Organise your investments in these bonds across maturities. This will ensure you get intermittent cash flows as bonds mature at different times. Take limited exposure only. “Investors may invest 5-15 per cent of their debt portfolio in these NCDs. Opt for shorter tenures like two, three, or at most five years in these ‘AA’-rated bonds. Also, opt for the monthly or annual interest option rather than the cumulative option,” says Parul Maheshwari, a certified financial planner.

Diversify your holdings

Do not shift money invested in FDs to these bonds just because they offer higher rates. “FDs are safer than NCDs. The latter should not be regarded as an alternative to the former,” says Chetanwala. Adds Maheshwari: “Bank deposits are insured up to Rs 5 lakh while NCDs are not.” Chetanwala suggests diversifying one’s debt portfolio into medium duration debt funds, banking and PSU debt funds, and corporate bond funds.

If you are not comfortable picking bonds and building a portfolio, but still want to take some credit risk to augment the return from your fixed-income portfolio, consider credit risk funds. Finally, even if you invest in these higher risk bonds, diversify across issuers.