and

Religare Fininvest NCD is offering a yield of 12.50 % p.a for a five year period

While State  Bank of India 8.5% p.a for a 5 year fixed deposit.

So what should you know before Investing in Non-Convertible Debentures?

WHAT IS A DEBENTURE?

A debenture is a debt paper issued by a company with the aim of raising money from the public. It has a specified tenure and offers a fixed interest rate called coupon.

DIFFERENCE BETWEEN CONVERTIBLE AND NON-CONVERTIBLE DEBENTURES

If on maturity the debentures are converted into shares of the company, it is a Convertible debenture and if the principle along with the accumulated interest is paid back to the investor it is a Non-Convertible Debenture.  NCDs are of two types Secured and Unsecured.

A secured NCD is backed by the assets of the company and in case the company fails to service its obligation (i.e.: defaults on the payment of interest or principle), the investor holding the debenture has a proportional claim to its assets, which are then liquidated. Unsecured NCDs are not backed by the assets of the company, hence are more risky. To compensate for the higher risk they offer a higher rate of interest compared to the secured NCDs.

Just to elucidate the IIFL issue was of unsecured and subordinate in nature. The DRHP stated:

“The NCDs will be in the nature of subordinated debt and hence the claims of the holders thereof will be subordinated to the claims of other secured and other unsecured creditors of our Company. Further, since no charge upon the assets of our Company would be created in connection with the NCDs, in the event of default in connection therewith, the holders of NCDs may not be able to recover their principal amount and/or the interest accrued therein in a timely manner, for the entire value of the NCDs held by them or at all. Accordingly, in such a case the holders of NCDs may lose all or a part of their investment therein. Further, the payment of interest and the repayment of the principal amount in connection with the NCDs would be subject to the requirements of RBI, which may also require our Company to obtain a prior approval from the RBI in certain circumstances.”

The Religare Fininvest was a secured NCD as is mentioned in the DRHP

“The principal amount of the NCDs to be issued in terms of this Draft Prospectus together with all interest due on the NCDs, as well as all costs, charges, all fees, remuneration of Debenture Trustee and expenses payable in respect thereof shall be secured by way of first pari-passu charge  in favour of the Debenture Trustee on an identified immovable property and a first  pari passu floating charge on the standard business receivables of our Company to the extent of at least 1.1 times of the amounts outstanding in respect of the NCDs at any time.”

WHAT TYPE OF INTEREST PAYMENT OPTIONS DO NON-CONVERTIBLE DEBENTURES OFFER?

Most NCDs have several payout options like monthly, quarterly, annual and cumulative payout.

FINANCIAL ASPECTS OF THE COMPANY THAT YOU SHOULD LOOK AT BEFORE INVESTING IN NON-CONVERTIBLE DEBENTURES

Before investing in a NCD, it would be wise to read its financial performance mentioned in the prospectus. You must check out financial ratios like Interest Coverage Ratio, Capital Adequacy Ratio and Non-Performing assets of the company.

Interest Coverage Ratio is determined by dividing a company’s earnings before interest and taxes (EBIT) by the company’s interest expenses in a period and shows how easily a company can pay interest on outstanding debt. Interest Coverage Ratio of 2 and above should be a positive sign, the higher the better.

Capital Adequacy Ratio shows how well the firm is capitalized. The current RBI mandated CAR ratio is 15% of NBFCs. So look for a CAR of more than 15% again higher the better.

Non-performing assets are loans which have turned bad. Percentage of NPAs to the total loan book indicates the asset quality of the financial institution. The lower it is the better. Rising NPAs are never a good sign and you must avoid investing in companies which demonstrate such a trend.

CREDIT RATING OF NCDS

As per RBI regulations corporates intending to issue NCDs shall obtain credit rating for issuance of the NCDs from one of the rating agencies, viz., the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. The highest possible rating is AAA. The lower the rating of the NCD, the higher is the coupon to compensate for the risk.

INCOME FROM NCDS, CAPITAL GAINS AND TAX

The coupon payment from NCDs gets clubbed with the investor’s income and is taxed at his or her marginal income tax rate, which is similar to interest income from bankfixed deposits. Since the NCDs are listed on the stock exchange, the investors can sell the instruments on the stock exchange prior to the maturity. In case he sells it within a year and makes a capital gain, he has to pay short term capital gains tax, which is taxed at the investor’s marginal income tax rate. If the NCDs are sold after a year, the investor has to pay a long term capital gains tax at 10.3% (including education cess of 3%) without indexation. It is important to note that indexation benefit is not available for bonds and debentures.

POST TAX YIELD ON NON-CONVERTIBLE DEBENTURES

Since the coupon payment from NCDs gets clubbed with the investor’s income and is taxed at his or her marginal income tax rate, it makes sense to look at the post-tax yield before investing. For example the Religare Fininvest issue offers a coupon of 12.50 % p.a. for a 5 year investment, the post-tax returns are as follows. So for someone in the highest tax slab, the NCDs are clearly not very beneficial considering the higher risk associated with them.

I hope now you would be in a better position to decide whether or not to invest in a particular Non-Convertible Debenture issue. However I would advise you not go overboard and invest a hefty amount in one single NCD issue.