Whenever a company wants to raise money from the public it issues a debt paper for a specified tenure where it pays a fixed interest on the investment. This paper is known as a debenture. Some of the debentures are termed as convertible debentures since they can be converted into equity share on maturity. A Non – Convertible debenture or NCD do not have the option of conversion into shares and on maturity the principal amount along with accumulated interest is paid to the holder of the instrument.
There are two types of NCDs-secured and unsecured. A secured NCD is backed by the assets of the company and if it fails to pay the obligation, the investor holding the debenture can claim it through liquidation of these assets. Contrary to this there is no backing in unsecured NCDs if company defaults. However, any company seeking to raise money through NCD has to get its issue rated by agencies such as CRISIL, ICRA, CARE and Fitch Ratings. A higher ratings (e.g. CRISIL AAA or AA-Stable) means the issuer has the ability to service its debt on time and carries lower default risk. A lower rating signifies a higher credit risk.
NCDs offer high rates to investors. The average rates in last few years have been 11-12%. Most of these were secured NCDs. Also, companies which carry higher risk give more than others to lure investors for investment. There can be various options for interest payout such as monthly, quarterly, half yearly or annually. However, most NCDs offer annual and cumulative payout. Investors wish to earn higher returns opt for cumulative option where the interest is reinvested and paid at maturity.
NCDs get listed on stock exchanges where investors can sell it before maturity. Any gain earned through selling in secondary market is termed as capital gains. What gains an investor will make depends on the interest rate scenario. If interest rates are higher than offered by NCD then the returns will be lower if sold through secondary markets and there might be negative return for investors in some cases. However, if there is fall in interest rates after buying NCD then selling on stock market may prove beneficial as the NCD will demand a premium.
NCDs have some inherent risk associated which an investor has to take into consideration before making any investment decision. The biggest risk is the credit risk. The company can default on the future payment and if it is unsecured NCD, an investor does not have any recourse. The second risk is the liquidity risk. Even if NCD get listed, low volumes (case of low rated NCDs) can deprive investors of any opportunity in exiting prematurely.
NCDs Vs FDs
NCDs and Bank fixed deposits (FDs) are both popular investment options for retail fixed income investors. An NCD is a type of loan that is issued by a company, which cannot be converted to equity. They are higher risk in nature when compared to a bank fixed deposits, since they run the risk of the issuer defaulting on repayments. Secured NCDs are safer than unsecured ones, but offer higher returns as well. Since risk and rewards go hand in hand, NCDs typically offer 200-250 basis point higher returns than the bank FDs at any point in time.