Context
In December 2021, several companies, including IIFL Home Finance, Indiabulls Housing Finance, Edelweiss Financial Services, and BlackSoil Capital (in January 2022) announced public issues to raise funds through non-convertible debentures (NCDs). These NCDs were offering interest rates between 8.25–9.7 per cent for different maturity periods. Housing finance companies, gold loan companies, and non-banking financial companies (NBFCs) are the major players in the NCD market. Apart from retail investors, banks, mutual funds, and insurance companies also invest in NCDs.
However, in the last few years there have been a number of defaults in the financial sector, including big names such as Reliance Capital Ltd, Dewan Housing Finance Corporation Ltd (DHFL), Infrastructure Leasing and Financial Services Ltd (IL&FS), wherein NCDs got stuck in these companies. This has made NCDs a risky venture to get into. In case of bankruptcy, NCD holders will be left with no choice. Such kind of defaults show the risks associated with investments in NCDs, especially for retail investors. Still, investors can consider investing in NCDs after evaluating the issuer’s profile.
What are Non-convertible Debentures
A debenture is a type of debt instrument that companies issue to raise medium to long-term funds from the public. In simple words, a debenture is a loan taken by a company from the public. Debenture holders are creditors or lenders of the company (unlike share holders who are owners of the company). Debentures are issued by the company for a certain period of time with a fixed rate of interest (called coupon payment). Debentures can be convertible or non-convertible.
Convertible debentures give the holders the option to get them converted into equity shares after a specific period of time. They can be fully, partially, or optionally convertible. They carry a lower coupon rate (interest rate) than non-convertible debentures.
Non-convertible debentures, as the name suggests, cannot be converted into shares or equities of the company. These are debt financial instruments used by companies to raise medium to long-term funds through a public issue. They carry a higher rate of return (coupon rate) than convertible debentures. NCDs can be both secured as well as unsecured. Secured NCDs are backed by assets of the company. In case the issuer is not able to fulfil its contract obligation, the assets are liquidated to repay the investors holding the debentures. Secured NCDs offer lower interest rates compared with unsecured ones. Unsecured NCDs are not backed by the assets of the company. As a result, they are riskier than secured NCDs.
It is obligatory for the companies seeking to raise funds through NCDs to get their issue rated by credit rating agencies, such as CRISIL, ICRA, CARE, and Fitch Ratings. NCDs with higher ratings mean the issuer has the ability to service its debt on time and there is lower default risk. As such, they are considered safe.
Why Non-convertible Debentures have become an attractive option
Until recently, bank fixed deposits used to be a popular investment option among retail investors looking to earn a guaranteed and secured return on their capital. However, declining rates on bank fixed deposits (currently around 6 per cent) combined with an inflation rate of 4–6 per cent have made the real rate of return very low. In such a low return environment, non-convertible debentures offering interest rates of 9 per cent or more have become a very attractive option for investors looking to earn a fixed and an assured income on their investments.
From purely an investor point of view, NCDs seem to provides a stable and regular source of income over a period of time. Investors with a moderate to high-risk appetite can consider investing in NCDs.
Risks associated with Non-convertible Debentures
There are certain risks associated with investments in non-convertible debentures. These include uncertainty with returns, credit risk or default risk, liquidity risk among others.
Uncertainty with returns: Investors generally prefer to invest in NCD issues of a company with high credit rating. However, it should be kept in mind that ratings are merely the opinion of rating agencies and not any sort of guarantee about the performance of the company. In the past, NCD issues of even AAA-rated companies such as Dewan Housing Finance Corporation Limited (DHFL) and Infrastructure Leasing & Financial Services Limited (IL&FS) defaulted. Investors in such issues were not able to get even their 100 per cent investment back.
Credit risk: Expected return from investments in NCDs should not be the sole criterion for investment. It is also important to factor in the credit risk. A credit risk is risk of default on a debt that may arise from the inability of the borrower to make required payments. When the economy is in good condition, everything looks good. In the event of an economic downturn, the risk of a corporate default is high.
Liquidity risk: It is the risk associated with the inability to meet financial commitments in a timely manner. Although NCDs are traded in stock exchanges, they have low liquidity. Unforeseen situations may warrant retail investors to dispose NCDs at a steep discount. Therefore, liquidity requirements need to be factored in before investing in NCDs and to get optimum returns, one should stay invested in NCDs till maturity.
Factors to consider before investing in Non-convertible Debentures
There are certain factors that need to be considered by retail investors before investing in non-convertible debentures.
The first and foremost is the credit rating (an analysis of the credit risks associated with a financial instrument or a financial entity) of the issuing company. These credit ratings are important as they give the investors information about the credentials of the company and the extent to which the financial statements of the issuing entity are sound in terms of borrowing and lending that has been done in the past. At the same, it is important for investors to not get carried away by current ratings. Rather, they should look at the historical ratings of the past one to two years. Secondly, the level of existing debt of the issuing company should be analysed to ascertain the sustainability of debt of the company. A sustainable level of debt will ensure that the company remains viable in the long-run. The third factor can be the capital adequacy ratio (CAR) of the company. CAR portrays whether the company has sufficient funds at its disposal to survive potential losses in future so that it does not reach the point of insolvency.
According to Nishith Baldevdas, founder, Shree Financial and a Sebi-registered investment adviser, the better judge of an NCD issue could be the quality of the business, sound management, and how diversified the company is. If it is a big conglomerate with good corporate governance and well-diversified business, then the risk factor gets reduced automatically. Because if one business fails, then owner’s credibility is at stake, so he or she will look to settle investors’ money by either liquidating other business verticals or taking loans from other entities.
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