NCD (Non Convertible Debentures) – Who can invest?

Many of us recently saw few NCD (Non Convertible Debentures) in the market which are offering you the higher interest rate than typical Bank FDs or Debt Funds. Who should invest in such NCD (Non Convertible Debentures)? What are the risks involved in such NCD (Non Convertible Debentures)? Let us see these in detail.

There are NCDs like DHFL or JM Financial NCDs which are offering more than 9% return to you. However, currently, banks are offering you the FDs at around 7% interest rate. How can they offer such high-interest rate and what are the risks involved here?

What are debentures?

Debentures are nothing but you are lending the money to the company. In return, the company is promising you the interest rate and return of principal at the specified time period. Then what is the difference between debentures and bonds?

In case of India, the difference between bonds and debentures are same. However, there are slight differences only the reasons for which companies borrow money from us (investors). Usually, bonds are meant for long-term company’s borrowing. However, debentures are meant for meeting short-term company’s requirement.

Types of Debentures

Let us now understand the different variants of debentures.

Convertible and Non-Convertible Debentures

Convertible debentures mean after the specified time, these debentures are converted into shares (stocks) of the company. Up to that conversation, you will enjoy the fixed specified coupon (interest rate) on such debentures. After that, your earnings depends on price appreciation of the stock or the dividend income you receive (if the company declares it).

Non-Convertible Debentures, on the other hands, will never be converted into shares (stocks) of the company. Investors who invest in such non-convertible debentures will enjoy fixed interest rate up to maturity and after that return of principal (exactly like Bank FDs).

Secured and Unsecured Debentures

Now within debentures, there is one category like secured and unsecured debentures. Secured debentures mean companies while borrowing money from you usually along with a promise to repay the interest and principal timely, put up some asset (such assets are free from any other encumbrances except those which are specifically agreed to by the debenture holders) as surety for the loan.

Secured means in case of the company goes bankrupt or goes something wrong, the company will sell such asset and repay you the money. Hence, secured debentures are usually safer than unsecured.

In case unsecured debentures, if the company goes bankrupt, then you will get the money when all such secured debtors amount is paid back. Hence, unsecured debentures are risky than secured and also because of such risk they offer higher interest rate to you than the secured.

Call and Put Option in Debentures

There are one more variants in case of debentures and they are usually called as Call or Put Option Debentures.

A CALL option means the company has an option to ask the investor to surrender the debenture after a certain period to them. In such situation, the company will pay back the principal to you.

Usually, companies exercise this option if interest rates go down, and the company can get funds at lower rates from the market. In such a situation, instead of paying you a higher interest rate, companies can exercise this call option and go for a cheaper loan.

On the other hand, a PUT option means that the investor has an option to surrender the debenture if he wants to, and get back his principal.

Suppose if interest rates go up and what you are receiving from your debenture is offering you lesser interest, then you can exercise this option and get back your money to invest somewhere else. A put option gives a lot of flexibility to the investor – if interest rates go up, and he can get better rates from the market.

Do remember that such CALL and PUT options are available to investors after holding the debentures for certain periods. Also, companies give you a time period to accept or exercise such options and within that period you have to exercise it.

Taxation of NCD (Non Convertible Debentures)

# Interest Income

The taxability of interest on NCD will depend on the method of accounting you follow for recognizing your income.

If you are following the cash method of accounting, interest will be taxable as and when the interest is received.

However, under the mercantile method of accounting, interest income on NCD will be taxable as and when interest is accrued and due.

Hence, interest income is treated as “Income from Other Sources” and treated accordingly.

# Short Term Capital Gain

If you held the debentures for less than a year and sold it in the secondary market, then any such gain from this selling will be taxed according to your tax slab.

# Long Term Capital Gain

If you hold the listed NCD, (cumulative or annual interest payment), for a period of one year or more, and on selling such NCD if you earn the gain, then such gain will be long-term capital gains (LTCG) chargeable to tax at 10% without indexation benefit.

NCD (Non Convertible Debentures) – Who can invest?

Many of us blindly invest with the lure of high returns from such debentures. As I told you earlier, currently few NCDs are offering you high-interest rate than banks.

Advantages of NCD (Non Convertible Debentures)

• These are good if you are looking for a constant stream of income. Do remember that few NCDs offer you to return interest and principal at maturity itself. Hence, in such situation, they act like typical FDs for you.
• Usually offers higher interest rates than the Bank FDs.
• These NCDs are listed in stock exchanges. Hence, in case of liquidity, you can sell it in the secondary market.
• Interest will be directly credited to your bank account. Hence, ease of managing money.
• There will not be TDS (Tax Deducted at Source) for these NCDs if you held them in demat format. Hence, in this feature, they have an edge over Bank FDs.
• It will give you diversification to your debt portfolio.

Disadvantages of NCD (Non Convertible Debentures)

• Credit Rating-Never trust the current credit rating and jump into investing. Credit rating may change at any point of time based on company’s financials. Hence, beware of credit rating.
• Liquidity-Even though such NCDs are listed in secondary market (like BSE or NSE), they are very thinly traded. Hence, you may face the liquidity issue.
• Post Tax Returns-Always check for post-tax returns on the interest you will receive. The formula to calculate the same is given below. Hence, a 9% NCD may not be same for 10%, 20% or 30% tax slab individuals.

Post-tax returns = Pre-Tax returns * { (100-Tax Rate) / 100 }

• Why company need the money-Check why they need the money? Why they are offering you higher interest rates than Bank FDs. If it is not possible to gauge the same by you, then knock the experts’ door and then only invest.
• HIGH RETURNS MEANS HIGH RISK-As I said above, if they are offering you the highest interest rate than Bank FDs, then there is always a risk involved. Mere SECURED DEBENTURES means not fully secure that you will get the money the next day after the company goes bankrupt.
• Check Financial Statement-Check financial statement of the company for the like how much % of their total asset the company allocating for unsecured loans, Capital Adequacy Ratio (CAR), how much % of their total asset is set aside for the NPAs (non performing assets) and like interest coverage ratio.

Hope this post will give you the complete picture of NCD (Non Convertible Debentures) details and also makes you informed investor about this product.