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May 22, 2012, 05.59 PM IST | Source: Moneycontrol.com

NCDs - Odds and Evens unravelled!

All the investments have their share of advantages and disadvantages. While Non-Convertible debentures are an attractive instrument in current market where equities are giving negative returns, it is also important to know what are the potential risks involved. Read on to know the risk and return payoff of this financial asset.

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In our previous article, we discussed about alternative investment option called Non-Convertible Debentures or NCDs . We will now discuss the risk and return payoff of this financial asset.

NCDs fall under a category called fixed income securities. This category includes all financial assets that give fixed returns every year. There are fixed income securities that pay their investors regularly but there are securities by companies that may not be regular. The rate of return mentioned by NCD issuers is not guaranteed.

Expected Returns from NCD

First, let's take returns. Returns are the rate at which NCD issuer pays to investors. Hence if Tata Motors issues NCD with rate of returns of 8%, investors can expect to receive Rs 8 out of every Rs 100 that they invest in.

Returns in NCDs vary widely. Today, the returns by many NCDs are as big as 14% while some might give just 10%. Now the question is why investors shouldn’t go for NCDs which provide 14% returns. Why should there be any NCDs in the market that pay less than the maximum returns available in the market?

The answer lies in two major observations by the market. One is the ability of NCD issuers to pay the investors. Second is the ability of NCD issuers to make enough money consistently. There are many factors that are considered but these two factors are of paramount importance. Rating agencies play the role of guide here. They are the ones who evaluate NCD issuers and assign a credit to the company based on its ability to generate cash consistently and pay investors on time. Remember that rating agencies just provide the rating and guidelines and they are in no way responsible for any loss of investments.

A higher rating means that the NCD issuer has consistent record of paying its obligation as well as generating money while a low rating means that company may face problems in paying its obligations.

Risks in NCD

Since NCDs provide higher return than the risk free rate, they expose investors to risk. The risk is lower than that of equities but it is certainly more than bank fixed deposits, Government bonds, and other Government schemes such as PPF, Post office, NSC etc. Let's look at some of the risks that investors are exposed to.

Business risk -

Unlike Government bonds and bank deposits where the returns are guaranteed, NCDs do not guarantee returns. In most cases, highly rated companies do fulfil their obligation consistently. However, there is always business risk that investors are exposed to. Businesses depend on many factors which are beyond the purview of companies. If these factors impact businesses of NCD issuers severely, they may find it difficult to pay the investors and may default in some cases.

For example, gas prices impact auto companies' business. Gas prices are Government regulated. Hence any adverse decision by Government on gas prices will hit auto companies severely. In such a case, if an auto company has issued NCDs, it may find it difficult to pay its investors.

Interest rate risk -

Investors of NCDs face interest rate risk. A rise in interest rate lessens the attractiveness of NCDs and hence the prices fall. Though fall in price may not impact the absolute amount of returns, it will reduce the returns when investors redeem their debentures. The logic is simple. When the interest rate rises, many investors may prefer to put money in bank as their deposit rates become attractive while the risk is nil. Hence the demand of NCDs go down which reduces its price.

Similarly, when the interest rate falls, its price rises as it increases the attractiveness of NCDs will increase.

Inflation risk -

Inflation is another major risk. Inflation eats into your profit. Most of the NCDs mention returns in nominal term which may not give right idea about the soundness of return. The real return will always be less than the nominal return. Real return, simply defined, is nothing but the nominal return minus the inflation. Hence if inflation goes up, the real return will go down.

Let's understand this with an example. If an NCD claims that it is giving 10% returns, your investment of Rs 1000 will become Rs 1100 in a year. However, if the inflation is 10%, the price of goods that costs Rs 1000 now will cost Rs 1100 in a year. This means even though you earned a return of 10%, you cannot buy anything extra with this money. You can still buy the same quantity of goods. Your real return was 0% in a year.

We have been facing inflation of 9%-14% for last couple of quarters. This means we have been getting negative returns on our investment in fixed income securities.

Finally

There are no guaranteed returns beyond the Government bonds and bank fixed deposits (even bank FD has risk but it is very low). Hence the moment investors see promises of returns larger than the returns offered by Government bonds; they should intuitively understand that this will expose them to risk. This is cardinal rule of investing.

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