What to look for when investing in NCDs

Tread carefully while investing in NCDs

Non-convertible debentures (NCDs) are popular among individual investors looking for regular income or looking to enhance returns from their debt portfolio.

The high-interest pay-outs from companies issuing NCDs are the first lure for investors. These issues are relatively smaller in size and are lapped up by retail and institutional investors alike, within the first few hours on opening day.

Earlier this week, Edelweiss Financial Services, came out with its second public offer for NCDs this calendar year, and the long duration 10-year NCD is offering up to 10.45 percent annual interest. Last month, IIFL Finance Limited, had an NCD offer where the 5-year bond was offering up to 9 percent annualised interest.

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However, the return is only one side of the investing coin, the other side is the risk. If the interest coupon offered is temptingly high, one has to question why the company is willing to raise funds at such a high price?

While good quality NCDs can provide an alternative investment in your debt portfolio, here are some dos and don’ts to keep in mind.

What you should know before you invest

The first thing to check after you have ascertained that the return is attractive is whether the NCD issue is secured against some assets of the issuing company. When you invest in an NCD issued by a corporate or a non-banking finance company, you are essentially giving them a loan for which they pay you a specified interest every year. Just like other loans, this too should have collateral attached in the extreme event of a default.

You will know that there is collateral if the NCD issue is a ‘secured’ issue. Check the collateral asset details in the prospectus. Usually for non-banking finance companies, the issues are secured against receivables.

You must also check the credit rating of the NCD; credit rating is given by authorised rating agencies to signify the financial health of a company and its potential ability to repay financial obligations. This has a direct bearing on your choice to invest in an NCD. A rating of AAA signifies the highest level of safety with a very high ability to continue financial payments.

“While the rating is important, keep in mind that the credit rating can undergo a change during the term of the NCD.” cautions Deepak Chhabria, Chief Executive Officer, and Director, Axiom Financial Services. If you are invested in a AAA NCD and the rating is downgraded, it can impact liquidity, making it difficult to exit and raises the risk of default.

It may be hard to dig into the details, but you can always work with your advisor and have a look at the financials of the company and more specifically, the free cash situation. Cash (on books) is indeed king if you are an NCD investor because a healthy cash balance signifies that the company will be able to meet its near to medium-term financial liabilities and interest payments without difficulty.

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What you can avoid

While the interest rate offered has to be attractive, don’t just chase returns. In the case of NCDs, understanding the default and liquidity risk is important. Default risk can be assessed with the help of the credit rating, whereas liquidity risk can be seen once the issue is listed on stock exchanges.

Along with the credit rating, to assess default risk, you have to consider the financial health, business growth prospects, and corporate governance of the issuing company. In the absence of this kind of research before investing, you are taking on the risk of losing your money. Ultimately, you are investing in one single company, which forsakes the advantages of having a diversified portfolio.

According to Amol Joshi, Founder, of Plan Rupee Investment Services, “Ideally, investors should avoid concentration risk which comes with investing in a single company or issuer. Alternatively, diversification, daily price or fund value per unit, and professional management are benefits you can get by investing in a portfolio of bonds through debt mutual funds.”

NCDs come with a lock-in, which means you have to stay invested for the specified time till maturity, after which you receive your principal back. In the interim, you receive the contracted interest payouts. However, these NCDs are also listed on stock exchanges, which means you have the option to sell in the secondary market before the maturity of the bonds. Ideally, you should invest money in a way that the maturity matches your requirements and you don’t have to sell before that. But liquidity through the stock exchange and secondary sale is somewhat like an emergency route.

Liquidity for NCDs is low in general and you shouldn’t rely on the secondary market for an early exit. Joshi says, “With a slight 50-75 bps compromise in yield you can get access to a portfolio of relatively better quality debt instruments in debt funds and there is daily liquidity too.”

Some bonds come with a monthly pay-out option; cash in hand may sound exciting. However, unless you need regular income, opting for the cumulative return option is better for compounding.

Interest on NCDs is taxable at your income tax rate, hence, you have to consider your post-tax returns not just the nominal interest coupon.

An additional red flag to watch out for is very frequent borrowing. “Could it be that this is to repay previous loans and the existing cash flow is not effective?” questions Chhabria.

If you are keen to invest in NCDs, then spread your investment across issuers. No single issuer should have more than 10 percent of your capital. Look at building a portfolio of NCDs factoring in your risk appetite and investment timeframe.

Lastly, while a long-tenure NCD of five years plus may offer higher returns, visibility on cash flow and financial health for such a long period is limited. Plus, locking in your money for so long might also mean an opportunity cost if interest rates head structurally higher.

Investing in corporate and NBFC NCDs can give your debt portfolio a lift in terms of returns, but you need to be mindful of details, not just of the issue but the company and its management. NCD defaults have been seen for large-sized organisations as well, hence, try not to be lulled into a sense of safety by the initial rating, rather keep abreast with key developments pertaining to the borrowing company.

If you want a higher return, there are no shortcuts, you must do your homework.