You must have come across advertisements inviting investments in corporate fixed deposits by many companies. The returns offered are quite high as compared to your regular bank fixed deposits. In fact, the mentioned yields are sometimes too attractive to ignore. So, should you invest in these corporate fixed deposits? In this article, we discuss various aspects that you must consider before deciding to invest in corporate fixed deposits. We shall also explain the hidden details behind these advertised eye catching returns. We shall also discuss the risks involved. But we must start with what exactly corporate fixed deposits are.
What are corporate fixed deposits?
Corporate fixed deposits or corporate deposits are just like bank fixed deposits. The difference is that the borrower is a corporate and not a bank. Like banks, companies (accepting such deposits) are obligated to make regular interest payments. Corporate fixed deposits typically offer higher interest rates than bank fixed deposits do but they carry higher risk too. Corporate FDs are unsecured. Bank FDs are secured to the extent of Rs 1 lakh. There have been many instances of defaults by companies on their fixed deposits in the recent past. Hence potential investors must appreciate the risk involved in investing in corporate FDs. One must understand that the companies would raise funds through fixed deposits for two reasons:
- They can raise funds through fixed deposits at a lower rate than they would from a bank
- They are finding it difficult to raise funds through banks or other financial institutions
As banks are not allowed to lend below base rate, many good corporates opt for corporate fixed deposits or non-convertible debentures (NCDs) to lower their cost of borrowing or even diversify their sources of borrowing. Many non-banking finance companies (NBFCs) and housing finance companies (HFCs) such as HDFC Limited, ICICI HFC, fall under this category.
There is another category of companies where banks have effectively shut their lending doors. Such either companies do not meet quality for loans under credit appraisal process used by the banks or are offered bank loans at extremely high interest rates. Such firms turn to public deposits to raise funds to churn existing debt or meet other fund requirements. Under the present scenario, real estate firms and construction companies fall under this category.
If you are planning to invest in corporate fixed deposits, make sure you invest in the FDs by companies falling in the first category.
Credit rating for corporate fixed deposits is not mandatory
It is not mandatory to get the corporate fixed deposits rated or disclose the rating to the potential even if the instrument has been rated. This is one of the reasons many stressed companies opt for fixed deposit route (instead of NCDs) to raise funds. However, most good companies get their fixed deposit schemes rated by debt rating agencies. Hence, stay from unrated deposits and invest only in highly rated (AA or above) corporate deposits.
As per extant regulations, interest rate offered on corporate fixed deposits is capped at 12.5% per annum. Hence, if the interest rate offered is at the upper end of the spectrum, it is a good indicator that the concerned corporate is struggling to raise funds elsewhere.
Regulations also require companies inviting deposits to provide net profit and dividend history for the last three years and information about past defaults (on payments to retail investors). This information can also be used, apart from the credit rating, to assess credit worthiness of the borrower.
Corporate FDs offers different interest rates for various tenors. Additionally, these corporate fixed deposits are typically available in two interest rate (payout) options: Cumulative and non-cumulative. Under the non-cumulative option, regular interest payouts (interest payment frequency depending upon investor preference) are made to the investor. Under the cumulative option, interest is reinvested and payment of accumulated interest and principal is made at the end of the tenor of the fixed deposit. Taxation treatment is no different from bank FDs and the interest is taxed at investor’s marginal tax rate. Premature withdrawal is allowed albeit with a penalty.
Pay attention to Compounded Annual Growth Rates (and not effective yield)
In the product brochures or advertisements, both interest rates and effective yields are mentioned. Let’s consider a corporate fixed deposit (cumulative option) by Mahindra Finance. As per the product details, under the 3 year option, the interest rate is 9.75% p.a. and the effective yield is 10.73%. Rs 10,000 invested in the deposit scheme grows to Rs. 13,219 at the end of 3 years. The absolute return is 32.19% i.e. (Rs 3,219/Rs. 10,000). Absolute return has been divided by 3 years to arrive at effective yield of 10.73%. This is a misleading representation. The compounded annual interest rate (CAGR) is 9.5% p.a. only (which is not mentioned anywhere). Such misleading representation is used to grab attention of customers. It is not that banks do not indulge in such tactics. However, we expect our readers to look beyond such pieces of information and be in a position to assess the true picture. One must calculate CAGR to evaluate the product offering.
How do corporate FDs fare against bank FDs?
Since corporate fixed deposits compete with bank fixed deposits for public funds, let’s compare the performance of Mahindra Finance FD with a 3 year fixed deposit from ICICI Bank which offers an interest rate of 8.75% p.a. (compounded quarterly). With ICICI Bank FD, Rs 10,000 will grow to Rs. 12,965 at the end of 3 years. CAGR is higher than specified interest rate (8.75%) at 9.04% because the interest is compounded quarterly. So, Mahindra Finance fixed deposit offers a higher CAGR of 9.5% p.a. (9.04% p.a. offered by ICICI Bank FD) although it carries higher risk. The comparison outcome is along the expected lines. Please note that these are pre-tax returns (CAGR). We have not compared post-tax yields since the taxation treatment of bank FDs and corporate FDs is similar. However, if you plan to compare corporate FD with an instrument with a different tax structure, then you need to compare post-tax returns.
Additional interest for senior citizens
An additional point to consider is that senior citizens get additional interest rate of 0.25% p.a. under Mahindra Finance fixed deposit and 0.75% p.a. in ICICI bank fixed deposit. This means, for senior citizens, CAGR for a 3 year Mahindra Finance deposit is 9.75% p.a. and ICICI Bank FD is 9.84% p.a. Hence, ICICI Bank FD offers better yield (CAGR) than Mahindra Finance deposit for senior citizens despite carrying lower risk. Hence, any senior citizen is better off investing in a ICICI Bank FD than a Mahindra Finance FD. Please note these calculations are pre-tax and are for a 3 year tenor. Results might be different for other tenors. Therefore, senior citizens must account for this additional interest to arrive at the final decision.
Corporate fixed deposits do offer higher interest rates and present an attractive investment option for those looking for interest rates offered by regular bank fixed deposits. However, investors must exercise some caution and keep following things in mind while investing in such deposit schemes.
- Opt for deposit schemes only from well established companies with a good track record
- Go only for those fixed deposit schemes rated AA and above
- Do not fall for interest rate or effective yield mentioned. Compute CAGR for comparison
Deepesh is Founder, PersonalFinancePlan.in