CDs: rates and risks, the complete guide4 min read . Updated: 13 Mar 2011, 09:53 PM IST
CDs: rates and risks, the complete guide
The biggest monster that stalks investment instruments is indisputably inflation. The best way to tame it is, of course, investing in equities, but only if the horizon is long enough and you have the appetite for the associated risk.
But what should individuals with low risk appetite do? Those who do not want to take too much risk, yet are not satisfied with fixed deposit returns can look at company deposits. They come with some risks, but if you invest cautiously, you can steer clear of these and reap higher returns.
What are these
Just like you make deposits with banks, you can put your money with companies in deposits run by them. Known as company deposits, or CDs, these carry a specified rate of interest over a fixed tenor.
Companies use these deposits to collect funds from the public and use the capital for expansion, for servicing debt or for any other purpose.
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“Any company which is incorporated under the Companies Act, 1956, is permitted to accept public deposits. Other companies such as partnership firms, societies or organizations cannot accept public deposits," says Satkam Divya, business head, Rupeetalk.com, a NetAmbit venture.
How do companies fix interest rates
The interest rate CDs offer is determined basically by two things. One, the need for cash by the company. The greater the need, the higher the rate the company would be willing to give.
Two, the time frame for which the company needs funds. Again, the longer the time frame, the higher would be the rate offered.
Some other factors, too, affect the rate of interest. “The higher the credit rating, the lower the interest rate. Also, a lot depends on the overall liquidity situation in the banking system. The tighter the liquidity, the more the interest rates," says Anil Rego, chief executive officer, Right Horizons, a Bangalore-based investment advisory and wealth management firm.
According to data provided by Rupeetalk.com, interest rates on CDs are between 8% and 12% per annum at present over various tenors, while that of FDs for various tenors is between 3.5% and 10.25%.
But what accompanies higher rates is higher risk.
Despite the fact that all non-banking finance companies are regulated by the Reserve Bank of India (RBI) and the rest by the Registrar of Companies, an investor still runs the risk of losing some or all his deposit.
A major risk factor is a company defaulting on its commitment. Worse, these deposits are unsecured instruments. So if a company defaults due to any financial problem, depositors’ claim will be settled only after the obligation of all the secured creditors are met.
Says Surya Bhatia, certified financial planner and principal consultant, Asset Managers, “The default risk is very high on company fixed deposits and recovering investments is a tough nut to crack. One has to take legal recourse to recover his investments but the process of justice is very slow in our country."
While bank fixed deposits of up to ₹ 1 lakh per bank branch are secured by Deposit Insurance and Credit Guarantee Corporation, there is no such guarantee on CDs.
In the past, many companies have defaulted on their obligation. “Morepen Laboratories Ltd, JVG Finance Ltd and Western Paques (India) Ltd are some of the firms which have defaulted on their commitments after accepting deposits from public," says Bhatia.
How to minimize risk
Just to get slightly high returns, you can’t turn a blind eye to the risks involved. However, a little due diligence may help you minimize the risk.
Credit rating: The first and the foremost thing that investors must look at is the credit rating of the company in which they plan to invest. These ratings are provided by independent rating agencies such as Crisil Ltd and Icra Ltd. Generally, the higher the rating, the more trustworthy the company is.
While RBI permits only “A" rated non-banking financial companies to accept public deposits, any manufacturing company can raise funds from public. “As a thumb rule, one should ignore unrated or little-known companies and prefer high-rated companies. High-rated companies are those with strong fundamentals and are unlikely to default," said Satkam.
Check promoter credibility: Investors should always do a background check on promoters’ credibility. One should not invest in companies whose promoters have a dubious background. “If a Tata group company offers 10% per annum and a relatively unknown company offers 11% per annum, one should invest in the Tata group company as the chances of losing deposits is negligible," says Ashish Kapur, chief executive officer, InvestShoppe Ltd, a Delhi-based brokerage and wealth management fund.
Don’t put all the money in one company: Investors should try to diversify risk by depositing money in companies engaged in various sectors. “Ideally, investors should not put more than 10-15% of their savings in one company. This would mitigate the risk considerably and even if any company defaults, investors will not lose their entire holding," says Rego.
Periodic review: For a better investment decision, it is very important for investors to do periodic reviews, ideally every quarter, of the company. The reviews should ideally be made every quarter. “Periodic reviews help decide whether an investor should renew his deposit. One should continuously check annual reports of the company and news related to the company," says Bhatia.
Investment tenor: Another important factor you should consider is the tenor of investment. The fundamentals of a company may change over a longer period of time and the chances of default increases. Hence, one should invest in company deposits for shorter periods, ideally for one-three years.
Avoid certain sectors: “One should avoid investments in shaky sectors or companies. For instance, if one has to take an investment decision in the current scenario, he should certainly not invest in real estate companies," says Kapur. Most of the real estate firms are facing cash flow problem.