Every few months, we see Non-convertible debenture (NCD) issues from various companies. As on date (September 7, 2019), the NCD issues from Tata Housing, Aadhar Housing Finance and IndiaBulls Commercial Credit are live.
Should you invest in such NCDs?
Well, in this post, I will not review any particular issue of NCD.
I will focus the benefits and risks involved in investing in such NCDs. I will discuss how to assess the suitability of Non-convertible debentures to your portfolio.
What is an NCD or Non-Convertible Debenture?
A debenture is a debt instrument that offers a fixed rate of interest for a specified tenure.
Debentures can be convertible or non-convertible. A convertible debenture can be converted into equity shares at agreed terms and conditions. A non-convertible debenture (NCD) cannot be converted into equity.
Debentures can also be secured or unsecured. Secured debentures are backed by security.
Here is a good video on how NCDs work.
What is the benefit of investing in NCDs?
#1 You get a higher rate of return than you will get with a bank fixed deposit. That is the only benefit I can think of. If the interest rate offered by NCD was lower than a bank FD, you wouldn’t invest in that particular NCD issue, would you?
#2 You will be able to lock-in the rate of interest for a considerably long time. Locking in a high rate of interest can be quite useful if you expect interest rates to move down in the near future.
#3 You stand to make capital gains if the interest rates move down. Bond prices and interest rates are inversely related. When the interest rates go down, bond prices go up.
Therefore, if you expect interest rates to move down in the near future, you can earn yourself handsome capital gains. However, this can be a double-edged sword. If your bet is wrong and the interest rates move up, you may even be staring at capital losses.
What are the issues with investing in NCDs?
#1 Interest income from such issues is taxable at your marginal income tax rate.
You need to consider the post-tax return. Even though the interest rate on NCD may be 9.5% p.a., the post-tax return is only 6.56% p.a. for an investor in the 30% tax bracket.
#2 Liquidity is an issue. Unlike bank fixed deposits or debt mutual funds that can be easily exited at any point in time, NCD investment can be exited only in the secondary market (apart from the normal exit at the time of maturity). To sell in the secondary market, you need to find a buyer. For many issues, that may not be very easy or the bid-ask spread may be quite high.
#3 You get exposed to credit risk
If the company defaults on the interest or the principal payments, you are in some serious mess.
Many times, in search of higher returns, we tend to ignore the associated risk.
Market dynamics ensure that the companies with lower creditworthiness will have to offer a higher return to attract investor interest. If you focus only on the interest rate on offer, you may be negatively surprised in the future.
Do not ignore creditworthiness of the issuer. There have been many cases of companies defaulting on the interest payments in such corporate fixed deposits /Non-convertible debentures.
Many companies especially NBFCs come out with such issues to lower their cost of borrowing. The banks can’t lend to them below their MCLR. If the company feels it can raise funds at a lower rate than the bank has offered, it can come out with an NCD issue. On the other hand, there are many companies which find it difficult to raise funds from the formal banking sector and thus have to reach out to retail investors to raise funds. Such companies must be strictly avoided.
Stick with good well known corporate names. In fact, many top-notch NBFCs hit the NCD market on a regular basis. You can sleep peacefully if you invest in such issues.
Stay away from issues by real estate or infrastructure companies.
One of the ways to assess the creditworthiness of the issuer is to look at the credit rating provided by Credit rating agencies such as CRISIL, CARE, ICRA and BWR.
It is mandatory for the NCD issued to get the issue rated by a credit agency.
You can stick with issues which have been rated AAA by credit rating agencies.
If you can go through the financial statements of the company to assess its repayment ability, nothing like it. Look at ratios such as interest coverage.
Tax treatment of Interest Income and Capital Gains from NCDs
Interest income is taxed at your marginal tax rate (income tax slab rate).
Capital gains from the sale of NCD will be taxed at your slab rate if you sell before 1 year.
Capital gains for sale after completing 1 year will qualify as long-term capital gains and will be taxed at flat 10% (without indexation).
NCDs are listed on stock exchanges. Therefore, you can consider exiting in the secondary market at a profit. If you have similar plans, do look at liquidity of earlier issues from the same issuer. Liquidity will also depend on other factors such as the size of the issue. For you to sell in the secondary market, there must be someone willing to buy and buy at a price you are willing to sell at.
How to buy NCDs online?
You can apply for NCDs online through broker websites. Most broker websites offer you this facility.
Should you invest in NCDs?
Depends on why you want to invest.
#1 If you are looking for capital gains, go right ahead.
If you are not really investing in NCDs for income but are simply planning to benefit from the downward movement in interest rates, go right ahead. You believe that interest rates will come down and you want to benefit. Fair enough.
Do note, for you to earn capital gains, the rates must move down i.e your belief or analysis must turn out right.
For an investor who has invested in NCD issue for income, subsequent movements in interest rates is a non-issue. The issuer will continue to pay contracted rate of interest for the entire bond tenure.
If you do not plan to invest for capital appreciation or need regular income, you must not invest in NCDs
#2 If you who have invested for regular income (and not capital appreciation), consider post-tax returns and other alternatives.
If your annual income falls below the minimum exemption limit, then the interest rate automatically becomes quite attractive.
Even if you fall in 10% tax bracket, the post interest rate is likely to be quite attractive. NCD with an annual interest of 9.5% will provide post-tax return of 8.55% p.a. for an investor in 10% tax bracket.
For an investor in 30% tax bracket, the post-tax returns from the same investment will be 6.65% p.a. Not as good.
Consider payment frequency too. If you want monthly payments but the NCD offers only annual payments, then the issue may not be useful.
#3 Consider alternatives that can provide better tax-efficient returns.
There are other ways of generating regular income. You can use your PPF account to generate pension income. Interest income from PPF is exempt from tax too.
Senior citizens have additional options in PMVVY and SCSS. However, since the interest income from PMVVY and SCSS is taxable, the post-tax return is likely to be lower than the NCD. At the same time, there is no credit risk in SCSS and PMVVY.
For better tax efficient returns (especially for those in the 30% tax bracket), you can consider Systematic Withdrawal plans from debt mutual funds too. With debt mutual funds, capital gains on units held for more than 3 years are taxed at 20% after indexation. Therefore, post-tax returns may turn out to be better. On a cautious note, there is risk in debt mutual funds too.
As you can see, there is no fixed answer.
You must assess post-tax returns and product suitability for your portfolio before investing.
Those who need regular income and fall in the lower income tax brackets can certainly look to invest in such NCDs.
And yes, do not ignore the creditworthiness of the issuer. Stick with quality names and issues with excellent credit rating. You must be comfortable with liquidity issues too.
A client who falls in 30% tax bracket asked me whether he should invest in a recent NCD issuance.
My answer was a clear No for two reasons.
- He falls in 30% tax bracket. Hence, his post-tax return is quite low.
- More importantly, he does not need the money to meet his regular requirements. So, he will eventually invest this interest income somewhere. Why not invest in that instrument in the first place?
For instance, if the rate of interest on NCD is 9.25% p.a., the effective rate of interest for him will be 6.39% p.a. Since he can afford to invest for the long term, he is much better off investing in PPF which offers him 7.6% p.a. (interest rate for July-September, 2018). You can check the latest PPF interest rate here.
You may argue that you cannot lock-in interest rate with PPF. Right, PPF interest rate is subject to change every quarter. However, the difference between 6.39% and 7.6% is still quite high. Moreover, you get tax benefit on investment in PPF under Section 80C. No such tax benefit for investment in NCDs.
In my opinion, even debt mutual funds can be a better option than NCD if you are investing for more than 3 years. With debt mutual funds, capital gains on the sale of units held for more than 3 years are taxed at 20% after indexation. If the client wants, he can even invest in corporate bond or credit risk debt funds to increase returns a bit (by taking additional risk).
This analysis was for my client. Your marginal income tax rate may be different. Your cash flow requirement may be different. Hence, you need to assess product suitability for yourself.
Are you planning to invest in NCDs? Do let me know in the comments section.