What makes NCDs attractive during volatile market?
Debentures are equivalent to debt that pays a regular interest to investors. They are usually issued by large companies with high credit rating. It is another way to raise fund by the companies. Debentures can be of many grades based on their risk exposure. Senior debenture holders have to be paid first. They can be easily sold and bought in the market.
Non-convertible debentures (NCDs)
Before we discuss non-convertible debenture or NCD, let’s understand what convertible debentures are. A convertible debenture is debt that can be converted to equity after a specified time in a certain ratio agreed by the company and debenture investors.
NCD are debentures which cannot be converted into equity.
Since convertible debenture offers the facility to convert them in equity at a later date, the interest paid is lower than what is paid in case of non-convertible debentures.
Just like debt, debentures can be secured or non-secured. Secured debentures are debt raised with collaterals while non-secured debentures are raised without any collateral. Needless to say, the secured ones are less risky. In case of possible default, secured debentures are backed by company assets which can be sold to pay to the debenture holders. Non-secured debenture holders do not enjoy such privilege. Since secured debentures are less risky, they pay lower interest than the rate paid by non-secured debentures.
A note on perpetual debenture
Last year, Tata power launched perpetual debentures. Perpetual debentures have no maturity date and are callable only by the company. The interest is paid every period. Perpetual debentures are very rare. The purpose of mentioning Tata power perpetuity debenture is not to recommend this but to mention a special class of debenture that runs for perpetuity.
There is increasing focus on debentures in India in recent times. Since 2008 crash, many equity investors are afraid to enter the market. Hence companies have found debenture as a better alternative to raise funds. In today's scenario, debentures can be a better option for investors. Let’s see why.
Debenture versus Equities - Equities expose investors to very high risk. The risk is higher when the market direction is unknown as is the case today. Moreover, when the economy is not rising as expected, any bad news beats down the market further. We have seen how policy changes in case of taxation, GAAR, telecom licensing, and gas policies hit the market. Debentures are safer in this respect, since they are typically issued by large companies. Debentures are graded by credit rating agencies. Hence investors can see which companies are financially strong enough to fulfil their interest obligation by looking at the grade assigned. This takes away much of the risk.
Debentures versus risk free investments - Risk free investments are the ones where the investments do not face any risk of default such as bank fixed deposits, Government bonds, and bonds issued by companies with high Government ownership. Since risk free investments offer no risk to investors, their returns are low. Moreover, with such a high inflation, the real return from risk free assets is negative. Debentures, while exposing investors to small risk, are still safe because of the backing by large companies with solid history of business behind them. With small risk, debentures can beat the returns by risk free investments easily.
Let's take a look at few of the debentures that have hit the market. The rate of return mentioned below gives you a range. The exact return depends on the type and structure of debentures. Similarly the maturity period changes with the type and series of debentures.
These debentures are given just to give examples of different features. You can check more details about these offerings before you decide to invest.
Feature of non-convertible debentures
NCDs are long term investment. The typical tenure is from 2 years to 20 years. Tax on debentures is simple. If investors sell debentures before a year, they will be liable to pay short term tax at the rate of your income tax. If investors sell it after a year, the long term tax applies which can be 10% without indexation and 20% with indexation. Debentures can be traded in the market like any other asset. Investors don’t have to keep it till maturity.
Look before you leap
Investors should not take interest rate or payment for granted. Market offers many choices in NCD space. The variety of interest rates, grades, and companies is wide. It is important to look before you jump into buying debentures.
First, compare the interest rate. There could be many companies that may offer better rate. Do your due diligence on returns and then only decide to invest. Additionally, please understand that high interest rate typically comes with low rating or high risk. Investors should look at the rating assigned by rating agencies to judge the risk of default. A higher rating implies low risk while a lower rating implies high risk.
Second, investors should also look for liquidity in debentures. If the debenture is liquid, you can come out of it whenever you wish without losing much value. Hence a liquid debenture offers you more flexibility. Illiquidity ones will block your money.
Finally, market price of debenture depends on interest rate. If the Government raises interest rates, the value of your debenture will go down in the market. It will not reduce your interest payment but the potential of capital appreciation will come down.
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