Planning to invest in NCDs? Don’t just go by the returns

In the last two months, around six different public issues for non-convertible debentures (NCDs), which offered an annual interest rate in the range of 9-10.25%, were launched. This rate of return is hard to resist in an environment where returns from market-linked securities have been so uncertain. Public issues of NCDs in the primary market are not the only way to access such debentures; there are privately placed issues too. Plus, once the primary issue is concluded, in most cases, debentures get listed on stock exchanges and investors can buy from there as well. 

But is an attractive annual return the only reason to buy an NCD? Investing in NCDs is far from simple. With an annual interest paid out at defined intervals, NCDs can make for a viable alternative in your debt allocation. However, there are many other important metrics you need to consider before committing any investment to this category.

Credit rating

The credit rating of a security indicates the likelihood of the underlying issuing company defaulting on its interest and principal payment. A rating of AAA, for example, indicates the highest quality or that the probability of default is extremely low. The next level is AA, where the default probability is still considered reasonably low. A credit rating of BBB and higher is termed as investment grade, which means it’s worth investing in as there is relatively low risk of default.

In a developing economy like India where many companies are still establishing their earnings, ratings can sometimes shift lower (or higher) quickly, leaving investors no time to respond if they hold a security which has been downgraded. For this reason, advisors recommend picking debentures from well-established, cash flow-rich and high-rated companies. 

“The institution which issues the NCD has to be credible, one which has been around for a while. The quality and established business is also reflected in a relatively high rating from credit agencies,” said Suresh Sadagopan, founder, Ladder7 Financial Advisories, a financial planning firm. 

Last month, there were debenture issues which offered an annual interest coupon higher than 10%. These debentures are rated AA and equivalent; if you are looking for the highest degree of safety, i.e., AAA rating, it will not make the cut. The interest coupon offered is inversely linked to the credit rating; investors are offered a premium yield for investing in lower-rated securities; hence, higher the yield, lower will be the rating (more credit risk) for a similar maturity debenture. 

A company which has low debt on its books and high cash balance is better placed to fulfil its payment obligations and this reflects in the higher credit rating such a company will have. 

Regular income 

Most NCDs will have several series on offer with varying tenures and the option to either receive payouts at defined intervals or get all the accumulated interest and principal back at maturity. 

The first step is to pick the tenure you want. This choice will depend on when you need the money and your long- and short- term goals. If the objective is to add to your long-term debt allocation for an element of stability in portfolio returns, you need to hold the bonds till maturity. For the purpose of regular income, you have to choose the defined payout option.

“Even NCDs from the secondary market can be bought for structuring into a regular income. In the secondary market, these are available in varying maturities and coupon. The payout is quarterly which helps get regular income and there is comfort in a bond issued by the state government. Tax-free bonds too are available in the secondary market at a very good price,” said Sadagopan. 

Your choice of regular income or accumulated interest at maturity will ultimately depend on your income needs. If you don’t need regular income, it is more efficient to go for the accumulated interest option as compounding results in a better yield.

Liquidity 

An important consideration is whether you will be able to exit or sell the NCD when you need to. For investors looking for an investment option with the objective to have incrementally higher portfolio return, the illiquidity in some NCDs may pose a problem as exiting the bond at the time and price you want may not be possible.

According to Shankar Raman, CIO–third party products, Centrum Wealth Management, “We don’t have too many investors with small ticket size requirements; liquidity then becomes an important point and locking into this for a 3-5-year period doesn’t make too much sense. We prefer other debt instruments which can be bought and sold in the market with ease and have better post-tax returns.” Large-sized investors often seek to maximise returns, in which case, exiting at an appropriate price is important. Low liquidity in some NCDs can be a dampener in such cases. On the other hand, debt mutual funds provide liquidity to investors and not all bonds listed on exchanges are illiquid.

However, when you hold NCDs till maturity, the issuer pays back the capital and liquidity is not an issue; the investment becomes predictable, giving stable returns and adding income to the portfolio.

Tax impact 

A 9.50% or 10% per annum interest coupon looks too tempting to let go, especially if it is offered by a high-grade company. However, for investors in the highest tax bracket, the post-tax return falls to 6.4-6.9% as interest payouts get clubbed with taxable income. 

However, for those in the lowest tax bracket, the post-tax return is 8.5%, which is attractive. Moreover, given the uncertain returns from market-linked products, investors may find some stability in regular payouts from NCDs. 

Whether you buy in an initial public offer or from the secondary market, treat your NCD investment as a buy-and-hold debt allocation, unless you have an advisor who can help you time a sell price in the market and manage liquidity. Also, keep in mind that you need to decide to invest in initial public offers of these debentures before the issue opens. There is a proportion of the issue reserved for retail investors, which gets oversubscribed quickly and allotment is made on first-come-first-serve basis.