Why does Prospero Tree recommend you to read this article?

While investing in bank fixed deposits is the most common form of investments for most of us, it is sometimes one of the most unattractive options too. Investing in an 8% FD will yield an after tax return of merely 5.6%, which is way below inflation. Non-convertible debenture (NCD) is a debt instrument which has lot of similarities with bank fixed deposits but offers higher returns.

Here is why you should read this article:-

1. NCDs offer higher returns vs. bank fixed deposit (generally 1-2% higher)

2. NCDs offer good diversification to your debt portfolio

3. Easy to invest and exit (online investment possible)

What is an NCD?

For beginners, they are like fixed deposits issued by companies. Companies opt for NCDs mainly to diversify their borrowing mix and reduce dependence on high cost bank borrowing. As an owner of the NCD, you are entitled to receive periodic interest payments and the principal amount at the end of the NCD tenure. Unlike the company's stock, which gets impacted by business fluctuations and market sentiment, NCDs will give you the assured returns if you hold it till maturity.

How is an NCD different from bank fixed deposits?

Fluctuation during the holding period: Unlike bank fixed deposits, NCDs can be traded on the stock exchange and price of NCD can fluctuate during the holding period. Consider an investment of Rs100 in an NCD, which matures in 5 years and pays an annual interest of 9%. The table below illustrates the returns that you would earn under different scenarios.

Table 1- Cashflows from NCD investing

* please note that NCDs can be sold only at market prices

If you hold the NCD to maturity, there is a complete surety of getting back the exact principal amount invested. In case you decide to 'break' the NCD at a time other than its maturity, you can sell it on the NSE or BSE through your broker. However, you have to sell it at the market price which may be different from Rs.100. The price of NCD fluctuates with changes in the interest rates in the economy with a thumb rule that the price of NCDs rise when interest rates go down and vice-versa. One must note that breaking a bank FD pre-maturely attracts a penalty in the form of lower interest rates and has no potential of capital gains.

'Impact cost' on selling an NCD: As mentioned earlier, if you wish to 'break' the NCD before its maturity, you have to sell it on the stock exchange. It is possible that there are not enough buyers for the NCD. In that case, you will have to wait for an appropriate buyer or sell at slightly lower prices vs current market price to attract buyers. For small investments (below 10lac), liquidity may not be a huge problem.

Default by the issuing company: It refers to the possibility of the company going bankrupt and unable to pay back your money. A good indicator of this risk would be the credit rating of the NCD. Anything above BBB should be good. For those who do not understand the rating system, companies with long track record and strong brands like L&T Finance, Shriram Transport, Shriram City, Manappuram, Muthoot and SBI are all good names and have little default risk. Although remote, banks too can default in case of a run on a bank or other macro calamity.

Prospero Tree view on NCDs

At Prospero Tree, we are of the opinion that NCDs will generally offer better returns compared to your bank deposits. Hence, NCDs surely deserve some allocation in your fixed income portfolio. For young, salaried employees with a long working life, it’s worth putting the discretionary money lying in your savings account into this instrument. The only thing one needs to be careful while investing in NCDs is to avoid taking unnecessary risks by investing in NCDs of companies with volatile business models - Unitech, JP Associates, etc.

How to invest in NCDs and which ones to invest in?

All you need is a demat & trading account with any broker. You can simply call up your broker or buy these NCDs online. In general, NCDs will offer better returns than FDs. Capital gains i.e returns on your principal amount can be really big if one invests at the time when interest rates are about to go down and cashes out when the interest rates are about to rise. Time and again, we highlight such opportunities for our investors. For details on which NCDs to invest in, refer to our article on current opportunities NCDs Recommendation Report.

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