Though company FDs offer higher interest rates than bank deposits, they carry more risks as well
While borrowers are rejoicing as loan rates have started to fall, depositors are feeling quite the opposite. The Reserve Bank of India on 29 September cut the repo rate—the rate at which it lends to banks—by 50 basis points. One basis point is one-hundredth of a percentage point.
As a result of the rate cut, banks are starting to lower their rates. Bank fixed deposit (FD) rates of State Bank of India (SBI) and other leading banks, with duration of five years and above, have fallen from around 9-10% at the end of 2013 to 7-7.25% per annum right now. And further reductions cannot be rule out. This means that bank FDs are less attractive and investors, especially senior citizens, seem to be a worried lot. On the other hand, company deposits, that return anywhere between 8% and 10% per annum at present, are beginning to shine in comparison. Unrated deposits offer even higher returns of 12-14%.
So, should you swap your bank FDs for greener pastures, i.e company FDs? For an answer you need to go beyond the comparison of interest rates alone. Mint Money tells you the risks involved and the rules that need to be followed while investing in a company FD.
Bank FDs are considered safer compared to company FDs that carry a greater risk of default. Bank FDs are insured up to 1 lakh under the Deposit Insurance and Credit Guarantee Corporation. And in the case of company FDs, the Companies Act, 2013 mandates that companies need to provide deposit insurance of up to 20,000 for every deposit accepted, but there isn’t any action on the ground as insurers are not willing to insure them.
The government, however, in recent years has taken certain steps to bring greater hygiene in company FDs. To begin with, last year the companies Act, notified that only companies with a turnover of over 500 crore and net worth of more than 100 crore could raise deposits. This means that only companies with a good financial standing can accept deposits. But the most important rule that was notified last year was the compulsory rating of all firms that accept deposits. The rule book further states that the rating needs to be obtained every year as long as the company holds depositors’ money. This is important as ratings help assess the safety of the company as regards its financial standing and repayment abilities.
“Rating is a relative measure to understand the debt servicing capability of a company. We review the past history and discuss future performance with the company before we assign ratings. Ratings are revised every year and are also reviewed when there are any major events impacting the business," said Ananda Bhoumik, managing director and chief analytical officer, India Ratings and Research.
Crisil Ltd, another leading rating agency, does the same. “Crisil continuously monitors the performance of the issuer and the economic environment it operates in. Analysts maintain periodic contact with the issuer to keep themselves abreast on the current developments and any changes in the issuer’s plans," said Somasekhar Vemuri, senior director, Crisil Ratings. And this is the reason why rated company deposits are considered safer than unrated ones.
To begin with, deposits accepted by real estate and manufacturing companies are best avoided. This is mainly because these are capital intensive sectors and suffer a cash crunch most of the time. “The assets, when it comes to certain manufacturing industries and especially real estate, is highly illiquid. Thus, usually we find that the credit ratings of such bonds or FDs are low, reflecting higher risk," said Hiren Dhakan, associate fund manager, Bonanza Portfolio Ltd.
Take Unitech Ltd for instance. It has been facing issues of delayed project handovers in its construction business. So, it comes as no surprise that there are several complaints against Unitech in consumer forums for non-repayment of principal as well as delays in interest payments on deposits (http://mintne.ws/1LlfuHp ) In fact, the Company Law Board directed Unitech to repay deposits within 30 days in May this year.
Another point to note is that you should stick to a company with high deposit rating. Experts suggest that one invest in deposits with ratings of AA+ and above. If you seek a high degree of safety on your investments, it is advisable to look at AAA-rated company FDs. This is the highest safety rating given by rating agencies and are given to those with excellent financial standing and repayment abilities. “We advice clients to look at FDs from groups with good management and are trustworthy," said Suresh Sadagopan, a Mumbai-based financial planner.
However, a deposit with a high rating doesn’t automatically become risk-free, Amtek Auto Ltd being a case in point. Amtek Auto, rated AA- by CARE and A by Brickwork Ratings India Pvt. Ltd, defaulted on its 800 crore worth of bonds that were to mature on 20 September. This happened after it reported a loss of 157 crore in the June 2015 quarter. The company had a debt of 7,844 crore as of 31 March 2015. In fact, the interest coverage ratio (measurement of the firm’s ability to meet interest costs) of Amtek Auto fell from 7 in March 2008 to below 0.1 in March this year. Depositors are still waiting to get their money. CARE suspended the ratings in August 2015, whereas Brickwork downgraded it from A to C, a month before the default.
This brings home the point that one shouldn’t blindly go by ratings alone. “Cases like Amtek Auto have been happening for decades. In the 90s, there were many examples. What is equally worrying was that even companies that did not default, took their own time to redeem deposits and investors had to chase companies to get their money back" said Arun Jethmalani, managing director , ValueNotes Strategic Intelligence Pvt. Ltd, a business intelligence company.
Therefore, the debt level of the company needs to considered . Higher increase in debt levels as compared to sales is a warning sign. “Debt to sales ratio of under 0.6-0.7 is considered comfortable" said Dhakan.
The second would be the asset turnover ratio; it measures how efficiently the company generates sales from its assets. A poor ratio indicates that the business is capital intensive and high growth rates are required to sustain the business. “Generally an asset turnover ratio of less than 1 is considered low," said Dhakan.
The third would be how much wealth was generated for shareholders. If the company is retaining most of its profits over several years and has failed to generate significant wealth for shareholders, then it is more concerned about its own business rather than investors’ interests. Amtek Auto failed on all these counts. If you are unfamiliar with these terms, get the help of your financial planner.
Another crucial point is to do some research on the company’s treatment of deposit holders. Check consumer forums online to see what other deposit holders say about the firm. The points to verify would include whether it is sending interest warrants on time and whether they respond to depositor queries quickly. “Company FDs always have a certain element of risk. It is best to go for the better rated ones and those that have a history of ethical behaviour towards investors and have a reputation of paying both principal and interest on time" said Sadagopan.
What should you do?
Refrain from committing a significant portion of your portfolio to these deposits. Company FDs are highly risky and illiquid. “If you can bear the inefficiencies of the company FD market, you could consider investing," said Jethmalani. And if you are a senior citizen you need to be much more cautious. “Compare, in money terms, how much extra you would get by investing in a company FD as against a bank FD. If it would be just about 2,000-3,000 extra per year, the risk is not worth taking," said Gaurav Mashruwala, a certified financial planner.
So, even though higher risks do lead to higher returns, calculated risks pay off better than just blindly investing in something. This applies perfectly to company deposits.