The attraction of ncds

Non-convertible debentures have some real benefits over fixed deposits.

The spate of interest rate cuts in the past several months has left fixed income investors with very few options. Rates offered for the traditional favourite, bank fixed deposits, have been hovering in the region of 5-7.5 per cent, based on the tenure of the deposits and the type of bank. Investors have been looking for better alternatives to fixed income instruments. One such that promises to deliver is a Secured NCD (Non-Convertible Debenture).

WHAT IS A NCD?
A non-convertible debenture is a debt instrument with a fixed tenure issued by companies to raise money for business purposes. Unlike convertible debentures, NCDs can’t be converted into equity shares of the issuing company at a future date.

The first one to raise money in recent times was by Tata Capital in February 2009. Fearing a tepid response to the NCD issue, the non-banking financial arm of the Tata Group had planned to raise at least Rs 500 crore, with a green-shoe (over-allotment) option of an additional Rs 1,000 crore. However, both company and bankers were in for a huge surprise, having received applications for more than Rs 2,500 crore. This has prompted many companies to come out with similar offerings, with the second one being Shriram Transport Finance in July and the latest one by L&T Finance.

Considering the interest rate scenario, many investors were keen to lock in to the high rates the NCDs had to offer. The L&T Finance coupon was the lowest of the lot, between 9.5-10.5 per cent but still it was oversubscribed at the end of the first day in the HNI (High Networth Investors, investment greater than Rs 1 lakh) and institutional categories.

Why this rush for NCDs when compared to a traditional Fixed Deposit? Here’s why:

 

Higher pre-tax & post-tax returns : The yields on Tata Capital and Shriram Transport have been in the range of 10.75-12 per cent, depending on tenure of the option. The maximum tenure for both these offerings was 60 months, whereas L&T Finance had a maximum tenure of 120 months. As compared to other options in the current scenario, the returns on NCDs are on the higher side. With monthly, quarterly, semi-annual and annual interest payouts (besides the cumulative option).

Even if you fall in the highest tax bracket, your returns, post-tax (30.9 per cent) will be 7.6 per cent (pre-tax yield of 11 per cent). If you are in the lower tax bracket of 10 per cent, the yields are much higher, and if you fall in the zero tax bracket, the entire interest is yours to keep.

Given the limited options one has, the returns offered by NCDs are very attractive and must be looked at for boosting post-tax returns. If you have a choice, you can invest in your parents’ name to benefit from the higher post-tax yield.

At the same time, it is important to choose your option wisely. A look at the interest rate table will clearly tell you that the cumulative option appears most attractive, as it offers the highest yield by allowing you to reinvest the interest at the same coupon rate (assuming the put/call option is not being exercised). In sum, you eliminate the reinvestment risk.

On the other hand, if you want a regular income, then you could also look for other interest payout options offered such as monthly, quarterly, half-yearly or annual interest payments, but the coupon rate offered is usually lower. 

No TDS & favourable tax treatment: Since NCDs are listed on the stock exchange and offered in a dematerialised form, they are not subject to TDS, unlike most bank and corporate fixed deposits. However, NCDs allotted to NRIs will be subject to TDS under Section 195 of the Income Tax Act.

Interest income from NCDs will be subject to your normal rate of taxation. NCDs can also be sold on the stock exchanges before maturity at a premium, incurring capital gains tax (if sold after one year, the long-term capital gains tax), which is lower than income tax for someone in the highest tax bracket. 

Decent liquidity options: To sell NCDs, one has two options. One, sell on the National Stock Exchange. Two, exercise the Put option (Tata Capital & Shriram had a Put option, whereas L&T Finance did not).

The key issue with the first option is lack of liquidity. Just because the NCD is listed on the NSE does not mean there are people willing to sell. Additionally, a sale on the NSE also entails an interest rate risk, This is because if the interest rate goes down, then the value of the NCD increases (which is great). However if interest rates go up, the value of the NCD goes down. However, if you hold the NCD till maturity, interest rate risk is eliminated.

Listing on the stock exchange also means you must have a Demat account, without which it is not possible to invest in NCDs. 

Better safety than corporate fixed deposits: NCD issues by NBFCs are secured debt, which means they are completely secured by assets of the company. Corporate fixed deposits, on the other hand, are unsecured and bank fixed deposits are secure to the tune of Rs 1 lakh only.

Despite the secured assets and high credit rating, NCDs are not 100 per cent safe and there is a risk of default that exists. Still, while interest rates on corporate FDs and NCDs are almost similar, the safety element and the potential to earn higher returns through capital appreciation makes NCDs a much better option. Even when compared to bank FDs, NCDs are a better alternative, as the returns are higher (post-tax is substantially higher with no TDS) at an incrementally higher risk.

Many investors did not get allotments or got a lower allotment in the Tata Capital NCD issue. Recent NCDs are now coming up on a first come, first serve basis. There might be a lot more NCD issues in the next 6-12 months. Apply on the first day itself if you are in the High Net Worth category, as a good issue (with double-digit interest rates, safety and a brand) will hit the HNI target on the first day itself.

The writer is director, My Financial Advisor