Non-convertible debentures (NCDs) are offering interest rates as high as 11% even as the debt markets are spooked given the crisis being faced by corporate groups, including IL&FS, ADAG Group, Essel Group and DHFL. Recent NCD issues include one by Muthoot Finance giving 10%, and by Indiabulls Consumer Finance offering 11%. NCDs, whose tenure ranges from 2-10 years, offer substantially higher interest rates than bank FDs but carry higher risk of default. Neil Borate asks four experts whether or not it makes sense to invest in NCDs in the current environment
Don’t let high interest rates sway you, look at the risks
As such, investment into NCDs is not recommended due to the risks associated with it. The biggest risk in an NCD is that of default i.e credit risk. In the current market, with NBFCs going through a liquidity crisis and higher rated papers also defaulting, it’s better to stay away from NCDs.
NCDs are also not liquid and it is not easy to exit before maturity as there may not be enough buyers.
The bigger risk in NCDs is the concentration risk an investor faces in his/her portfolio. With NCDs, the investor exposes the portfolio to a single company, thus jeopardizing the capital at unfavourable times.
In addition, NCDs are not tax efficient instruments and investors are better off investing in debt mutual funds which provide better diversification, liquidity and the benefit of professional fund management.
Investors must not be swayed by the high interest rates that NCDs offer and must keep in mind the risks associated with these. The negatives associated with NCDs far outweigh the positives.
The current market scenario in debt markets is hardly healthy. Serious concerns persist about investment decision drivers like ratings, ability of firms to refinance debt with mutual funds and the liquidity of debt instruments in the secondary markets. This is reflected in the higher yields prevailing in recent NCDs.
Investors are better off sitting out this trade as what we see is surely not reassuring. If mutual funds have not been able to ensure timely return of capital of unit holders by borrowers, a retail investor has to be realistic about his own bandwidth to manage such situations.
There are strong reasons to be doubly concerned and careful. The distress in capital raising is not going away anytime soon. Retail NCDs which normally are seen as costly instruments will essentially be a last resort of capital hungry businesses. It would be prudent to stay away from risks of retail debt investing that NCDs present.
The markets need more regulatory reassurance and rebuilding of credibility in ratings.
One should look to invest up to 25-30% of investible surplus meant for fixed income investment in NCDs, under overall asset allocation.
Preferably, such NCDs should be secured by a collateral to reduce the risk significantly in case of a complete default. One can also look at the credit rating of at least two rating agencies to ascertain the risk involved. Most companies get ratings through agencies like Crisil or Care or Icra.
Interestingly, in times like now, even good quality NCDs offer higher risk-adjusted returns owing to low investor sentiment and high credit crunch. Most investors benefit from such situations which demands a higher compensation in terms of higher yields.
Also, assess the issuing company’s financial health and the reason why it’s raising money through NCDs. Short- to medium-term borrowing through NCDs by companies has comparatively lower risk of defaults, as per historical data.
Overall, it’s worth it to ride the higher yield curve by having a certain allocation to NCDs.
NCDs have higher yields than FDs but one should note the credit risks attached with NCDs. These risks can largely be judged by checking the credit rating but ratings can change. For instance, IL&FS was downgraded to D rating, from the highest credit rating of AAA in less than two months.
Mutual funds offer a second layer of gate-keeping by assessing the quality of papers independent to credit rating. For clients needing to invest in fixed income for medium-term goals, MFs make sense for many reasons. First, debt funds in several categories would have assets spread across at least 40 securities or papers, reducing risk. Second, if the client holds a fixed-income fund for more than three years, the applicable long-term capital gains is 20% after indexation, minimizing tax liability. Third, investments can be pulled out in full or part anytime, subject to interest rate, liquidity and credit risks. Fourth, side-pocketing (which is yet to take off) can separate risky assets. Fifth, mutual funds are able to mirror market returns as they are marked to market