What are the pros and cons of investing in NBFC NCDs?

A company is always in need of finance for various purposes like the expansion of business, getting new plant and machinery, diversification, meeting its working capital needs, etc. These finance needs are met through various sources like getting a loan from banks or NBFC, raising funds through the issue of equity shares, rights issues, debentures, bonds, etc. 

The company analyses these sources on the basis of the time taken to generate the funds, various regulations for the mode of raising finance, the cost of funds, and a cost-benefit analysis of raising finance through a particular source among other parameters. Among the various finance options, debentures are often considered to be popular with many companies as they can be issued easily and do not have stringent regulations as in the case of equity shares. 

Given below is a brief discussion relating to the meaning of NCDs and the pros and cons of investing in NCDs from the investor perspective. 

What are NCDs?

When we talk about debentures, not many would be aware of the different types of debentures that can be issued by a company. NCDs are Non-convertible debentures that are issued by a company as a form of raising the necessary capital to meet its financial requirements. The basic difference between convertible debentures and NCDs is that the former can be converted to equity shares upon the option of the debenture holder provided it is accepted by the company, however, the Non Convertible Debentures (NCDs) cannot be converted into equity shares or stocks. 

NCDs are usually unsecured which means that unlike secured debentures they are not directly backed by any asset of the company. Investors have to rely on the creditworthiness of the company and their due diligence to ascertain the viability of their investment. 

Like convertible debentures, NCDs also provide interest at a fixed rate known as the coupon rate which is declared by the company at the time of issuing the NCDs. This interest is credited to the investors on regular intervals like monthly, quarterly, semi-annually or annual basis depending on the agreement between the issuer and the subscriber of these debentures. The maturity period of NCDs is also fixed and upon maturity, the investors receive their principal amount along with the interest accrued. 

What are the features of NCDs?

Some of the key features of NCDs that make them an attractive option for the companies and the investors are highlighted below.

1. Different types of NCDs

NCDs are broadly categorized under two main categories namely, secured NCDs and unsecured NCDs. The secured NCDs are backed by a specific asset or collateral and can be liquidated in the event of any default by the issuing company. The interest rate for such NCDs is relatively lower. The other type of NCD is the unsecured NCD which is not backed by any asset or collateral and is the most commonly issued NCD in the market. The rate of interest for such NCDs is higher than that for secured NCDs.

2. Increased interest rate

The most attractive feature of NCDs is the higher interest rate offered by the companies for subscribing to NCDs. Unsecured NCDs have further higher interest rates as compared to secured NCDs. This excess interest rate is the reward enjoyed by the investor for taking a risk on the company and also foregoing the benefit of conversion to equity shares offered by convertible debentures. The interest rate is directly proportional to the risk of investment. When the NCD is offered by a low-rated company, the risk of investment is higher which is translated into higher interest rates. 

3. Liquidity

The NCDs are issued mostly by reputed companies that have a good credit rating by top credit rating agencies. This assures the investors of the viability of their investment as well as returns on the same. Also, NCDs have a limited lock-in period and are also listed on recognized stock exchanges. Therefore, they can be easily traded by investors and earn short-term gains for the same or exit their investment if they do not find it favorable. Investors can subscribe to the NCDs through recognized stock exchanges or during a public issue when subscription can be done within a limited time span. 

4. Taxation

The taxation for NCDs is similar to any other debt instrument. The gains earned by the investors can be short-term or long-term depending on the period of holding. Short-term gains are taxed at the applicable slab rates while long-term capital gains are taxed at a flat rate of 20% after the benefit of indexation. 

What are the pros or advantages of investing in NCDs?

The key advantages of investing in NCDs are discussed hereunder.

1. Higher interest rates: The prime advantage of NCDs is the higher interest rates as compared to traditional investment options like bank FDs, government bonds or securities, etc.
2. Tradable on the exchange: Listed NCDs can be traded in the open market making the investment liquid as well as an opportunity for capital appreciation
3. Carry priority charge on the assets of the company: NCDs, even if they are unsecured, have a priority charge in the company’s profits over equity shareholders. Therefore, the investment of the investors is more or less considered to be a secured investment.
4. Sound investment: Before issuing the NCDs, the creditworthiness of the company is reviewed by competent credit rating agencies, and the company is also closely regulated by RBI. This further increases the confidence of the investors in the company’s future prospects.
5. No TDS on interest earned: Interest earned through NCDs is not subject to any TDS but is taxable at your slab level.

What are the cons or disadvantages of investing in NCDs?

The major limitations faced by NCDs are highlighted below.

1. Fixed return: The biggest disadvantage of NCDs is that the returns do not take inflation into account. The post-inflation returns from NCDs may not be as attractive as compared to other dynamic investment options available in the market.
2. Subject to tax: The post-tax returns from NCDs may be quite lower as compared to other debt investment options like debt mutual funds or hybrid mutual funds.
3. Non-convertible to equity shares: NCDs are not converted into equity shares and hence, investors do not get the benefit of becoming shareholders of the company eventually.
4. Possibility of lesser sound companies issuing NCDs: Companies having a lower credit rating have a higher risk of default and may not return the principal and interest accrued upon maturity.

Eligibility to issue NCDs

The issue of NCDs is subject to the guidelines of SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021. According to these guidelines, a corporate is entitled to issue NCDs provided they meet the following conditions. 

• The said company should have a tangible net worth of Rs. 4,00,00,000
• The company has been sanctioned a working capital limit and/or a term loan from any bank or all India finance institutions
• The borrowing account of the corporate should have been classified as a standard asset by a bank or the financial institution(s)

Conclusion

NCDs are an effective mode of raising capital for companies. The credit rating of the company has a direct impact on the coupon rate offered by the company. From the perspective of investors also, NCDs are better investment options as compared to traditional investments like Bank FDs, and Post Office Time Deposits as the interest rate is relatively higher and NCDs are also considered to be liquid investments.  

FAQs