How NCDs stack up against FDs

There are significant differences in their regulation, structure and risk profile

If you’ve been disappointed with the low returns from your fixed deposits lately, you may be quite tempted by Non-Convertible Debenture (NCD) issues from NBFCs that promise yields of 9-plus per cent.

The returns on these debentures are clearly much higher than the fixed deposit rates offered by popular NBFCs, which are still stuck at 8 per cent.

So how does an NCD differ from an FD and how do you evaluate it?

Differing regulations

While both NCDs and FDs represent money investors loan to companies, there are significant differences in their regulation, structure and risk profile.

As the RBI is quite stringent about allowing any non-bank entity to accept public deposits, only NBFCs specifically registered with it as ‘deposit-taking’ NBFCs (https://rbi.org.in/scripts/NBFC_Pub_lic.aspx) can accept FDs from the public.

Even in this shortlist, only NBFCs with an investment grade credit rating are allowed to accept fixed deposits. Their total deposits are capped at 1.5 times their net owned funds; they can only accept deposits for 1-5 years and cannot offer interest rates higher than 12.5 per cent per annum. Auditors must regularly certify their ability to repay their deposits.

NCD issues by NBFCs, being capital market instruments, face far fewer restrictions, and are regulated by SEBI. They are required to make detailed disclosures to investors through a comprehensive ‘shelf prospectus’ that contains company details, financials and risk factors, and a ‘tranche prospectus’ that discloses the interest rates, maturity dates, end-use and the security backing a specific NCD issue. Every NBFC which issues NCDs has to disclose its credit rating, and maintain a debenture redemption reserve amounting to 25 per cent of the outstanding NCDs.

Often riskier

Despite these SEBI norms, NCDs are often riskier than FDs on three counts. One, NCDs can be offered by below-investment grade companies while FDs can be offered only by investment grade ones.

Two, defaults or delays in payment of FDs are viewed far more seriously by regulators than those in NCDs. When a company defaults on FDs, you can complain to the Company Law Board or Consumer Court, or file a civil suit. But in the case of default on NCDs, investors are expected to first approach the company’s debenture trustees for remedial action.

Three, NBFCs that are not authorised by the RBI to accept fixed deposits often approach the bond markets with high-yielding NCDs for their fund requirements. For instance, SREI Infrastructure Finance, Kosamattam Finance, Muthoot Fincorp and JM Financial have recently floated NCDs, but do not have RBI registration to accept public deposits.

Now that you are aware that NCDs are often riskier than FDs, here are four parameters to evaluate an NCD offer by.

Credit rating: Most retail investors are inclined to invest in NCDs that offer the highest premium in rates over bank deposits. But higher the interest rates, the more the default risk you’re taking. Credit ratings assigned by rating agencies are a good way to gauge the extent of default risk. Usually, NCDs rated A to AAA (single A to AAA) carry low default risk, while those rated BBB or below carry moderate to high levels of default risk. But you need to check on the credit rating of your NCD not just at the time of investment, but also during your holding period as ratings can change anytime until maturity.

Security backing: An NCD can either represent a secured or an unsecured borrowing. A secured NCD is safer because if the company runs short of funds, the collateral can be liquidated to repay you. However, even for secured bonds, the nature of the collateral matters. A ‘first charge’ on the company’s assets or ‘senior debt’ that ranks pari passu with other creditors means that your rights on the NCD are well-protected. But a ‘second charge’ or ‘subordinated debt’ indicates that you rank lower in the pecking order than other creditors.

Tenor: Longer-term bonds often look attractive on paper because they allow you to lock into fixed rates. But they entail two kinds of risk. It is difficult to evaluate the credit-worthiness of a company over long periods as the business may undergo drastic change. If market interest rates rise, you lose the opportunity to shift into higher-yielding instruments. So avoid NCDs with more than five-year lock-ins.

Calls and puts: Sometimes, while issuing high-yield NCDs, companies leave an escape hatch open to redeem the bonds early. To gauge this, check for a call option in the tranche prospectus. A put option similarly allows you to make an early exit from the bond.

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