Why does Breathing Stocks recommend you to read this article?

At Breathing Stocks, it's been our endeavor to present good investment opportunities and at the same time, keep you away from over-bombardment of information. While most of us are familiar with bank fixed deposits, there is an attractive alternate option called the non convertible debenture (NCD). This article aims at making you understand the advantages and dynamics of NCDs,

such as:-

1. NCDs offer higher returns but have lot of similarities to bank fixed deposit

2. NCDs are easy to invest and exit

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.

What are the different kinds of NCDs?

Secured vs. Unsecured: Secured NCDs are covered against certain assets of the company. In case the company defaults on its re-payment obligation, the company may have to sell off its assets to repay the debt holders. This makes the secured NCDs a safer investment than unsecured NCDs. Unsecured NCDs generally offer higher interest rates as the risk is higher compared to secured NCDs.

Taxable vs. Tax-free debentures: This classification is based on the treatment of interest income received from debentures. Generally, interest income from the debentures is added to you total income and you have to pay taxes on it based on your marginal tax rate. In-case oftax-free NCDs, the interest income is completely tax free. So this becomes a very attractive option for individuals falling in 20% or 30% tax bracket. We will see a slew of tax free bonds issued by companies such as NHAI, PFC, REC, HUDCO, IRFC, and so on in the years to come.

Table 1: Key NCD terminologies

Term	Description
Tenure	It can range between 1 to 20 years. The NCD can be redeemed even before maturity as there is no lock-in period in this investment.
Coupon rate	This is the coupon or the interest rate that will be paid to the investor by the company against the borrowed principal.
Coupon frequency	The interest payment can either be annual, quarterly or monthly.
Credit rating	The ratings indicate the quality of the issue. It is mandatory for the company issuing the NCD to get the issue rated by a credit rating agency like CRISIL or ICRA.
Listing	This states the stock exchanges on which the issue will be listed and can be traded thereafter. Eg: BSE/NSE
Yield	Once the NCD is listed on the exchange, its price will fluctuate based on movement in general interest rates. Yield to maturity is the effective returns that you earn by investing at a particular point in time

The tenure, interest rate, interest payment and credit rating are disclosed in the NCD issue document.

Below are the details of a few NCDs that were issued over FY12 and listed on the stock exchanges. As an illustration, Muthoot Finance came out with its NCD issue in Sep-11 with a coupon rate of 12.3% per annum. As on 14-Nov-2012, it traded at Rs1,075 vs. its issue price Rs1,000 per NCD. For someone investing in the Muthoot Finance's NCD on 14-Nov-2012 at Rs982, the effective yield that he earns over the life of the NCD is 12.9%.

Table 2: Illustration of few listed NCDs - prices as on Nov'12

What are the typical risks associated with NCDs?

Credit risk : 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, invest in NCDs of companies with long track record and good brands.

Liquidity risk : As mentioned earlier, if you wish to 'break' the NCD before its maturity, you have to sell it on the stock exchange. It is highly possible that there are not enough buyers for the NCD and you may have to sell at slightly lower prices vs. current market price to attract buyers. For small investments (below 10lac), liquidity may not be a huge problem.

Prospero Tree View

At Breathing Stocks, we are of the opinion that NCDs will mostly offer slightly 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.

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