Debt funds or NCDs – where should you invest?

NCDs or non convertible debentures and bonds issued by corporates to raise funds for their business from individual investors among others.

Some of the recent NCDs are being offered at coupon rates of 8.5% – 8.75% per year. Given the low-interest rates offered by fixed deposits and even some types of debt mutual funds, it may be tempting to allocate funds here.

However, while returns are visible, consider the risk as well before putting in your money.

NCDs come with all kinds of risks including interest rate, credit risk and liquidity risk. Let’s see how these debentures compare with debt funds on these three aspects.

Interest rate risk of NCDs

When interest rates change, bond prices react by moving in the opposite direction. If interest rates in the economy are moving up, prices of existing bonds tend to fall.

The opposite also happens. In a falling interest rate scenario, the prices of existing higher-yielding bonds tend to rise thanks to a higher demand to earn better yield.

In the case of NCDs, if you plan to hold till maturity, this risk will not affect you because you will receive all your interest payouts and the principal at the end.

In short term debt mutual funds like liquid funds, interest rate risk is not relevant. That’s if you match your holding period with the average maturity of the scheme. However, in debt funds, because the price is market-linked and published daily, the interim value of the scheme can fluctuate thanks to interest rate risk.

The risk becomes real if you want to exit either the NCD or the fund before the expected holding period and tenure.

Credit risk of NCDs

Most public issues of NCDs come with an assigned credit rating from rating agencies like CRISIL, ICRA and so on. The credit rating is reviewed periodically and is based on the company’s financial and fundamental health.

If the company is unable to retain its credit rating thanks to weakening financials or corporate governance, the bond gets downgraded. As a result the price of the bond or debenture also falls.

This risk of lower return thanks to capital loss from a falling bond price, is referred to as credit risk. The opposite is also true and if the credit rating of a bond is upgraded, there can be significant price gains.

However, credit risk can go deeper than just a change in the price of the bond.

If the credit quality keeps deteriorating, there’s a chance that your interest payments and finally the repayment of principal is negatively affected. You can lose all your money if the credit risk turns to default risk.

This kind of risk is high when you hold single, non- AAA rate or highest quality bonds.

In a well-managed debt fund, the risk is mitigated by having a portfolio of 15-20 (or more) bonds, thereby spreading the risk. Even if one defaults or suffers a credit downgrade, the others can deliver.

Learn Difference between Bond and Debenture

Liquidity risk

Lastly, NCDs although listed, have not found much favour in terms of secondary market volumes. This means individual bonds don’t get traded every day. If you decide to exit sooner than the proposed tenure or maturity, you may not be able to find a buyer at the price you want.

This is a risk you are unlikely to face with mutual fund schemes. The schemes themselves offer daily liquidity. A set of debt mutual funds had severe liquidity issues last year forcing them to wind up. That incident, though, should be considered more an exception and not the norm.

Managed funds like corporate bond funds also deliver in terms of returns as they are active investors in corporate debentures.

Risks are defused in such managed funds as compared to single debentures, while returns remain attractive.

However, in funds too, you must check on the portfolio credit quality and consistency of performance before making an investment.