Investors are queuing up for NCDs due to volatile markets. But, not all offers are good
NCDs or non-convertible debentures are suddenly flooding the market. The month of August has been, and is, witnessing back-to-back NCD issues from IIFL, Shriram City Union Finance, Mannapuram Finance and Muthoot Finance. Besides, there are several NCDs like those of L&T Finance, SBI, Tata Capital and Shriram Transport, which are already listed and traded at attractive yield in the secondary market. Investors' sudden interest in these instruments is mainly because of the attractive rate of returns (a little above 12%) and the slump in the equity market. However, every NCD may not be as attractive as the return it offers. Investors should do their homework if they want good returns along with the safety of capital.
CHECK THE FINANCIALS
Every NCD on offer comes with a prospectus. Investors should go through it carefully before investing. If the company is listed, investors can also check its annual reports and latest financial statements. Reputed companies keep their annual reports on their websites. Quarterly numbers are available on stock exchange websites.
Always pick a company that is making profits and with a healthy dividend-paying record. In the case of NBFCs, check their exposure to various sectors. This is because high exposure to sectors like real estate and capital markets may not augur well for the company. You can also find out whether the company has borrowed from banks and financial institutions, as it increases your margin of safety as banks are large institutions and would have done their due diligence before giving a loan to the company.
Also, check out the various ratios, like profitability ratios and debt-to-equity ratio to see if they are in line with the industry norm. One ratio that can help investors make a decision is the interest service coverage ratio. It shows how easily the company can pay interest on outstanding debt. It is arrived at by dividing the earning before interest and taxes (EBIT) with the interest expense. Higher the number, the better it is from an investor's point of view. A number less than 1.5 is a sign of risk, as the company may find it difficult to service debt in the near term if rates move up.
Since NCDs can be both secured and unsecured, one should prefer to invest in secured NCDs. A secured NCD necessitates that the company creates a charge on its assets. In case of liquidation of the company, NCD holders will be paid first over other entities who lent money to the company, which gives further safety for the investor.
RATINGS AND INTEREST RATES
NCDs are rated by credit rating agencies. Rating gives a fair idea about the company's financial strength and its debt repaying capability. So while an NCD of SBI was rated AAA, indicating highest degree of safety with regards to timely repayment of principal and interest, the NCDs from Mannapuram Finance were rated AA-, indicating a high degree of safety. One also needs to remember that ratings can change from time to time. If you are holding NCDs, you need to keep that in mind. Any downgrade in rating could lead to lower returns. You trade risk for return. A company with lower rating has to pay higher interest rates to raise money while a company which enjoys a higher rating, pays lower interest rates. Besides, one should also compare the coupon rate with other fixed-income instruments. So, while AAA-rated NCDs give a yield of 9.4%, AA- rated NCDs pay 12.25%, which is 285 basis points higher to compensate for the lower rating.
This is the premium the issuer is paying to get people invested and is good for the investor. Also keep the taxation issue in mind before buying NCDs. Interest earned on the bonds comes under income from other sources and investors are liable to pay tax on the same. Any sale done in less than a year is subject to shortterm capital gains tax, which is the marginal rate of tax of an individual. For long-term capital gains, the tax, according to current norms, is lower of 10.3% without indexation or 20.6% with indexation.
CHECK LIQUIDITY
Whenever you buy bonds, buy it with a perspective of holding it to maturity. This is because though NCDs are listed on the stock exchange, they may not necessarily be liquid. Volumes generally are low and there is a vast difference between bid and ask price in many cases.
In addition, bonds are subject to interest rate risk. When interest rates move up, bond prices move down and vice-versa. In a rising interest rate scenario, the NCD price can go below the face value and the investor may be forced to exit at a loss.
PUT AND CALL OPTIONS
A put option means the investor has the option to sell the NCD back to the issuer at a particular time, while a call option means the company has the option to repay the NCD money before it matures. In a rising interest rate scenario, a put option will work in the investors', favour while in a falling interest rate scenario, it will work in the company's favour. While the first issue of Tata Capital launched two years back had a put and call option at the end of 36 months, the issues of Muthoot Finance and Mannapuram Finance do not have these options.
TERM
If you are keen to invest for the long term and can hold on till maturity, you better go for it now, as interest rates are said to be peaking. As global economy turns weak, interest rates may come down. So, if you are comfortable investing and holding for a term of five years, it can be a better bet. There is a hidden benefit for a long-tenure NCD, say of five years and more.
These instruments are more sensitive to changes in interest rates. If the rates were to fall, the prices of NCDs on bourses may move up, offering room for capital gains if you decide to log out before maturity.
Last, but not the least, keep diversification of portfolio in mind. Do not get carried away and put all the debt component of your portfolio in NCDs, just because they are paying a high interest rates. Investors need to diversify across other fixed income products and at best should allocate 10-15% of their debt portfolio to NCDs.
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