Beyond high returns: How to evaluate risk before investing in NCDs

The secondary market for corporate bonds and NCDs in India is developing very rapidly.

With interest rates falling and stock markets trending flat, non-convertible debentures (NCDs) that offer higher interest rates may appear attractive to investors. However, this also means additional risk.

NCDs are popular among individual investors seeking regular income or higher returns on their debt portfolio. Their main attraction is the high-interest payouts offered by issuing companies. These NCD issues are typically small in size and often get fully subscribed quickly, drawing strong interest from both retail and institutional investors.

For example, in July, Edelweiss Financial Services launched a Rs 300-crore NCD issue with an effective yield of up to 10.5 percent.

Higher interest payouts may be attractive, but they shouldn’t be the only factor in deciding whether to invest in NCDs or not.

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“With falling interest rates in bank FDs (fixed deposits), NCDs offer an interesting opportunity for investors to earn 10-12 percent fixed returns. Investors should analyse the NCD details, specifically looking out for the issuer and its credit rating, the tenure of the NCD, the yield (returns) and interest payment frequency,” said Suresh Darak, Founder, Bondbazaar.

The starting point for assessing NCD risk is its credit rating. All NCD issuers are rated by Sebi (Securities and Exchange Board of India) -accredited rating agencies, such as CRISIL, ICRA, and CARE. These ratings range from AAA (highest safety) to D (default). Ratings of AA and higher are considered investment-grade. New investors should opt for NCDs that have higher credit rating and are thus have higher safety.

Much like how a strong CIBIL score improves loan eligibility and lower borrowing rates for individuals, a higher credit rating indicates stronger repayment capacity for the issuer.

“However, it is not a guarantee. Investors must review the issuer’s financials – particularly debt levels, cash flow, and interest coverage ratio. In addition, the tenure and structure of the instrument (secured vs. unsecured) play a critical role. Longer tenures generally increase exposure to changing market conditions,” said Vishal Goenka, Co-Founder, IndiaBonds.com.

Another key aspect is the issuer’s financial health. Issuer releases their cash flow statements, annual reports and other financial metrics on a regular basis. Investors should look at key parameters which shows the financial health of an issuer like debt-to-coverage ratio, revenue and margin growth, net worth, interest coverage ratio etc. Strong financials determine lower risk associated with the issuer.

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“Investors should also keep an eye on historical track records of the issuer regarding any defaults in principal and interest payments, and related news to understand the future business path the company is heading to,” said Nikhil Aggarwal, Founder & Group CEO, Grip Invest.

Credit Risk: This refers to the possibility that the issuer might default on interest or principal payments. That’s why we always look at credit ratings and do a thorough check on the issuer’s financials and repayment track record.

Interest Rate Risk: If market interest rates go up after you’ve invested, your NCD’s fixed return might not look as attractive anymore. This mainly affects investors who may want to exit before maturity, as it can impact the market value.

Liquidity Risk: Unlike stocks, NCDs aren’t always actively traded. So, if someone wants to exit early, they might face trouble finding a buyer or may have to sell at a lower price.

Structural Risk: Things like whether the NCD is secured or unsecured, the tenure, and call or put options also matter. These structural features directly affect how safe or flexible the investment really is.

The risk profile of an NCD issuer is affected by the sector and concentration of assets.

“For example, an issuer giving gold loans is typically considered ‘safer’ than an issuer giving personal loans because the former is backed by real assets. However, if the personal loan portfolio is only a small part of the overall business, then it changes the equation,” said Darak.

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Some companies, like those in FMCG or medicine sectors, earn money regularly through daily sales, so they usually pay back bond investors on time. Others, like infrastructure companies, they get paid in stages from big projects, which still works well but follows a different schedule.

“Every industry has its own rhythm. For example, real estate or metal companies may do really well during growth periods, while utilities or consumer goods tend to do well almost all the time. So, you can pick bonds based on what suits your comfort level. Companies that sell in many places or have many products usually handle challenges better. This makes their bond payments more reliable, since they don’t depend on just one thing to earn money,” said Tushar Sharma, Co-founder of Bondbay.

There are over 10,000 listed NCDs on NSE and BSE, and close to Rs 100 crore worth of NCDs are traded everyday.

“However, liquidity varies significantly, depending on the issuer, rating, and size of the issuance. Well-known, highly rated issuers tend to have better trading volumes, while smaller or lower-rated NCDs may remain illiquid. Although the secondary market for NCDs is still developing, the emergence of Online Bond Platform Providers (OBPPs) has improved access and liquidity, compared to a few years ago,” said Goenka.

Depending on the NCD, investors have priority rights over the assets of the company. If there is a delay or default in payment, the company may go for liquidation, after which the company assets are sold and the collected money is returned to investors. In some cases, NCD holders get full repayment, sometimes partial.

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Sebi  regulations outlines issuer’s obligations and draw mechanisms to protect investors.

Debenture Trustee: All listed NCD issues appoint a Sebi-registered Debenture Trustee. The trustee acts on behalf of the NCD holders to safeguard their interests. In case of delay or default, the trustee is responsible for taking necessary action to protect investors' rights, which may include legal actions. In case of default, the trustee initiates recovery under the Insolvency and Bankruptcy Code (IBC) for secured NCDs.

Voting Rights: Under the Companies Act 2013, in case an issuer defaults, bond holders have the right to vote on resolution plans during insolvency proceedings.

“In case of defaults, sometimes payment terms are renegotiated with creditor and in severe cases asset liquidation occurs to cover for secured NCDs. Thus, it is important to look at security cover and covenants while choosing an NCD,” said Aggarwal.

Security Cover and Covenants: The terms of the debenture include protective covenant clauses that restrict the issuer from taking certain actions that could increase risk (e.g., taking on more debt, selling secured assets, or making large dividend payments). Breach of these covenants can be treated as a technical default, giving investors early warning and potential legal recourse.

A structured checklist can prevent emotional decisions based solely on high yields.

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Issuer analysis include checking business model, promoter & management quality, financial health of the company (Check the last 3-5 years of financial statements), what is the Debt-to-Equity ratio (a high ratio indicates higher leverage and risk) and the sectoral outlook.

Next comes analysing the issue. “Check the credit rating. What is the rating? Is it from a reputable agency, is the NCD secured or unsecured? If secured, what are the assets backing it? Then, look at the coupon rate: how does the interest rate compare to a bank FD and other NCDs with a similar rating? Then comes tenure. Does it align with your financial goals? Lastly, what are Call/Put Options? Does the issuer have a 'Call Option' (right to repay early)? Do you have a 'Put Option' (right to demand early repayment)? A call option is generally unfavorable for investors,” said Tushar Sharma, Co-founder of Bondbay.

Then check your risk appetite. Does this NCD match your personal risk tolerance? The investment horizon and diversification in terms of the number of NCDS and sectors within the NCDs are also important.