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Non-Convertible Debentures

High returns accompanied by a high-risk level
 

Muthoot Finance's second non-convertible debenture (NCD) issue this year opened last week and would be available till January 7. Several others like L&T Finance, Shriram Transport and Tata Capital plan to follow soon.

The investment tenure here varies from two to five and a half years and requires a minimum investment of ~5,000. The annual returns range from 13-13.43 per cent, varying across tenures. The returns, this time, are up from those offered during the previous issue (12 per cent) that opened earlier this year, and is possibly the highest being offered by any debt instrument in the market right now.

An NCD is a type of loan issued by a company that cannot be converted into stock. They offer high returns, but are risky instruments and may not suit all investors. Liquidity is another issue. In a rising interest regime, getting out of a bank deposit may be easier than liquidating your NCD investment, because these are listed on stock exchanges, and may have to be sold at a discount if there aren't many trades happening.

As compared to bank fixed deposits, the returns are higher by almost three-four per cent. Currently, State Bank of India (SBI) is giving 9.25 per cent for deposits between one and ten years.

Gilt funds are another option. These invest in long-term government securities. Since many believe the interest rate cycle is near its peak, locking in funds is advisable. Plus, even if the interest rates start moving down, you will benefit through capital appreciation. Over a five-year period this category has returned seven per cent, according to Value Research, a mutual rating agency.

All these returns are pre-tax, though. The interest earned on the NCDs and bank deposits will be added to your income and taxed according to slab. So, for those falling in the highest tax bracket, the effective returns for NCDs would be 9.25 per cent (for 13.43 per cent return). For fixed deposits, these would be at 6.4 per cent.

Comparatively, gilt funds will be more tax efficient, with capital gains taxed at 10 per cent and 20 per cent, with and without indexation, respectively.

The higher returns of NCDs, however, require ahigher risk appetite. Reason: Though the returns are locked in and the issue secured, there is always the risk of default. Typically, the company would earmark assets against the amount raised. So, these can be liquidated to pay off the borrowers in dire situation. This is small respite. If the overall business fails, the earmarked security can also be compromised and the investor will get nothing.

In this NCD issue, investors can consider investing a small portion in the shorter tenure (two-year) option, according to Malhar Majumder, director, Gliese Consulting, to cap any risk involved, and take advantage of the high returns.

Thus, any decision for investing in this or further NCD issues must be taken after evaluating the business fundamentals or the business model of the company. You can look at the credit rating assigned to the issue for guidance. For instance, the rating assigned to the Muthoot Finance issue is AA-/Stable by Crisil, implying high safety, with the minus sign reflecting comparative standing within the category.
 

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