NCDs provide a good investment opportunity for fixed-return investors, provided it’s a highly rated paper issued by a company. You should know the risk factors associated with NCDs to decide on which NCD to choose, for how long, and when to invest.

What are NCDs?

Non-Convertible Debentures (NCDs) are fixed-return instruments issued by companies. As the term suggests, unlike other debentures, NCDs can’t be converted into shares on maturity.

Types of NCDs

NCDs are of two types – secured NCDs and unsecured NCDs.

Secured NCDs are backed by company assets and are safer compared to unsecured ones. In case of default, investors may press for liquidation of the issuing company to recover money by selling its assets.

Unsecured NCDs are riskier compared to secured ones as they are not backed by company assets, but may offer higher rates of interest to attract investors.

Returns

NCDs provide fixed rates of interest payouts at regular intervals to investors during the investment period or as specified by the issuer at the time of issuance of the NCDs. The interest rates offered are generally higher than fixed deposits (FDs) issued by banks and corporates. The interest payout interval may vary – monthly, quarterly, half-yearly,  yearly or at maturity on every NCD.

As listed NCDs are traded in stock exchanges, investors may buy or sell the instruments without investing for a full maturity period. As a result, apart from a fixed rate of interest, NCDs may have high or low yields, depending on buying and selling prices and the period of holding.

Maturity Period

Companies issue NCDs for both short-term and long-term periods. The maturity period of NCDs may vary from as short as 1 year to as long as 20 years. Investors, however, have the option to exit early by selling NCDs in secondary markets. The higher the maturity period, the higher will be the interest rate risks.

Liquidity

Compared to FDs, NCD investors may have additional liquidity as they may buy or sell the instruments in secondary markets. However, NCDs are not as liquid as company shares, as there may not be many buyers in the secondary market every time. 

Ratings

Although NCDs generally provide a higher rate of interest compared to some other fixed-return instruments, the higher return may come with higher risks. So, investors should look for NCDs having higher ratings for the instrument and the issuing company as well. Rating agencies like CRISIL, ICRA, and CARE Ratings provide ratings to companies on the basis of their financial strength and weaknesses and the NCDs issued by the companies on the basis of the default history of a company and the purpose of the issue of NCDs. Along with the rate of interest, it’s also very important to check the ratings of NCDs before investing to avoid default risks.

Taxation

When an investor purchases NCDs from the issuing company during the issuance period and holds the instruments till maturity, he/she has to pay tax on the interest earned. Like FDs, the interest earned on NCDs during a financial year in such a case will be added to the income of the investor – under the head “Income from Other Sources” – to calculate the tax payable for that particular financial year.

Transactions in the secondary market

When NCDs are transacted (bought and/or sold) in the secondary markets, along with the tax on interest earned during the holding period, investors may have to pay capital gain taxes as well depending on the holding period.

Tax on STCG

Short-term capital gain (STCG) may arise when NCDs are sold before the completion of 12 months from the date of investment. STCGs on the sale of NCDs are added to the taxable income of the investors and are taxed as per the tax slab of the respective investors.

Tax on LTCG

Long-term capital gain (LTCG) may arise when NCDs are sold after 12 months from the date of investment. LTCG on NCDs is taxed at 10% without indexation.

Risks

Following are some of the risks that NCD investors may face:

Default/Credit Risk

If invested in a high-risk NCD of a financially weak company, investors may not get timely interest. In the worst case, they may not get interest at all and may also lose the capital invested in case the issuing company becomes bankrupt.

To avoid such a situation, you should invest in the NCDs having high credit ratings issued by highly-rated financially strong companies. You may also invest in secured NCDs as they are relatively safer than unsecured ones.

Interest Rate risk

If invested in NCDs during rising rates of interest, the investors have to receive lower interest during the investment period compared to the NCDs and other fixed-interest instruments issued at a higher rate subsequently. The interest rate risk increases with the increase in the investment period.

Moreover, to avoid getting lower interest during the entire investment period, if an investor tries to sell the NCD in the secondary market, he/she will face capital loss as the NCDs bearing a lower rate of interest will fetch a lower value. So, in case of a financial emergency, NCD investors – especially long-term investors – may suffer capital loss while liquidating their instruments in the secondary markets.

Is it a good decision to invest in NCDs in the current market scenario?

At present many countries – including India – are increasing policy rates to fight high global inflation. Starting from May 2022, the Reserve Bank of India (RBI) has increased the Repo Rate 5 times – first by 40 bps in May, followed by a 50 bps hike each in June, August, and September. Another hike of 35 bps in December 2022 makes the Repo Rate 6.25% – a hike of 225 bps or 2.25% – from 4% before the recent rate hike spree that started in May 2022.

With the increase in the Repo and Bank rates, there is a fair chance that the Companies will also issue NCDs at a higher rate. So, before investing in any NCD, you should always compare the risk and the actual returns with similar options or any other investment option available in the market. After evaluating all these You can invest some part of your free money to diversify your investment and minimize the Risks. 

Final Thoughts

As the return of capital is more important than the return on capital, you should take a calculated and well-planned call while investing in long-term NCDs. In order to avoid the risk, be cautious about the credit ratings and overall financial performance of the issuer and keep an eye out for good entry points.

Frequently Asked Questions (FAQs)