Debentures are long term debt instruments that the company issues to raise capital from investors. They carry a fixed interest rate for a specific period. A company can issue different types of debenture, namely convertible and non convertible debentures. Convertible debentures can be converted to equity shares of the company. On the other hand, non convertible debentures do have such an option on maturity.
What is a Non Convertible Debentures?
A Non convertible debentures (NCD) is a debt instrument where the issuing company cannot convert them into either equity or stocks. Usually, big companies issue them to raise capital without giving them an option for conversion into equity. Generally, NCDs are not backed by any collateral. Investors can only rely on the issuing company’s creditworthiness and the ratings given by the credit agencies. These ratings help investors understand the issuer’s credit worthiness and future expectations.
NCDs carry a fixed interest rate. They have a fixed maturity date, and interest is payable either monthly, quarterly, half-yearly or annually, depending on the terms at the time of issue. Upon maturity, the investor will receive the principal amount and interest payment. Compared to convertible debentures, investing in NCD offers various benefits, including liquidity, low risk, and tax benefits.
Types of Non Convertible Debentures
The following are the two types of non convertible debentures
Secured NCD is safer among the two as the company’s assets or any collateral backs them. If the company fails to pay the promised amount on time, investors can claim their dues by liquidating its assets. However, the interest rates on these NCDs are low.
Unsecured NCDs are riskier than secured NCDs as the company’s assets or any collateral does not back them. If the company fails to pay back the investors, they have no choice but to wait until they receive their payment. The company has no assets to recover its dues. In other words, the company pays these investors only after paying the holders of secured NCDs. Moreover, the interest rate of these NCDs is higher than the Secured NCDs.
Features of Non Convertible Debentures
Investors can subscribe to NCDs during the public issue within a specific time frame. Also, they are listed on a stock exchange where investors can subscribe through the registered brokers.
NCDs have higher liquidity as it is mandatory to list them on a stock exchange. Thus, investors can buy or sell NCDs anytime in the secondary market. This is an essential feature as this can help you arrange cash in case of emergencies.
The interest rate offered by an NCD is generally higher than that of a fixed deposit. Also, the interest rates of unsecured debentures are higher. They have the flexibility of interest payments either monthly, quarterly, half-yearly or annually. Furthermore, they have a cumulative payout option as well.
NCDs are very flexible in tenure, with a minimum tenure of 90 days to maximum tenure of 10 years. Investors can opt for short or long term NCD based on their investment objective.
The company that issues NCDs has to approach credit rating agencies such as CRISIL, CARE, ICRA, etc., for ratings. It plays a significant role in determining the creditworthiness and the potential of the company to fulfil its obligations towards the creditors. A company with high credit ratings implies fulfilling its obligation, whereas a lower credit rating company has higher credit risk. Thus, if the issuing company defaults payments, the agency will downgrade its rating.
The taxation of NCD is the same as debt taxation. If the investor sells the NCD within three years, then STCG will be applicable as per the income tax slab rate. Subsequently, if the investor sells the NCD after three years, LTCG will be applicable at 20% with indexation.
Advantages of Investing in Non Convertible Debentures
- Every company that seeks to raise capital by issuing NCDs have to go through the rating agencies like CRISIL, CARE, ICRA, etc., to verify the information provided.
- Upon maturity of NCD, the investor receives the principal amount and interest directly to their bank account.
- These debentures offer higher interest rates than convertible debentures and fixed deposits.
- NCDs are listed on a stock exchange that provides liquidity to investors. Thus, investors can buy or sell in the secondary market.
- The company that issues NCDs is closely regulated by the Reserve Bank of India (RBI), benefiting investors.
- In case of liquidation, the company has an obligation to pay the NCD holders in priority than the equity holders. Thus, they are a safe investment option.
- NCDs do not attract TDS on interest earned. The interest income is added to the total income while filing income tax returns.
Disadvantages of Investing in Non Convertible Debentures
- Unlike convertible debentures, the NCDs cannot be converted into equity shares of the company after a specific time period.
- Unsecured NCDs that are not backed by any company assets can default the principal and interest payment. However, the secured NCD holders are paid by liquidating the company’s assets.
- There are companies with low credit ratings issuing NCD with higher interest rates. However, these companies may default their payments on maturity, affecting their creditworthiness.
- In case of bankruptcy, secured creditors are paid on priority. Thus, the unsecured debenture holders will have to wait until they receive their payments.
Things To Consider While Investing in an NCD
The following are things the investor should consider while investing in an NCD.
The credit rating is the foremost thing that you must consider for NCDs. You must choose a company with a higher credit rating, i.e. AA or above. Credit rating shows the company’s potential to sustain its operations and credibility. Thus, a higher credit rating of the company, safer the investment.
Before investing, you should check the financial statements of the company. This will give an insight into the company’s assets, debt-equity ratio and other statistics about the company’s financial position. Also, the company should not be heavily financed by debt.
Capital Adequacy Ratio (CAR)
This is a statistical indicator of whether the company has enough funds to survive during the potential losses. The company has to maintain this ratio, and you must check this ratio historically before investing in an NCD.
The company should regularly keep assigning provisions for its non-performing assets. This ensures that the company is generating profits to meet its obligations and mitigate the risk for its investors.
Interest Coverage Ratio (ICR)
The interest coverage ratio determines the number of times the company can service its debt obligations using its current earnings. In simple words, it depicts the company’s ability to handle debt payments. A higher interest coverage ratio is a sign of a healthy company.
Purpose of NCD
You can choose to invest in an NCD that meets your financial objective and investment horizon. Companies issue NCD to raise funds for a specific purpose. This purpose should be clear and not ambiguous to ensure that the company uses investors funds for valid reasons towards the growth of the company. Thus, the offer document should provide this information.
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