Non-convertible debentures do not attract TDS and are easier to trade than company FDs

Conservative investors always long for extra returns with no risks attached. They weigh every bit of interest that they can earn more from an investment. And every penny saved on taxes is the icing on the cake. However, these days investors are facing a dilemma. Though interest rates in India are rising, rates on fixed deposits are not keeping pace. The increased cost of living is another problem that most riskaverse investors have to deal with. No wonder, fixed-income investors are trying to find out ways to boost returns.

Those investors who are not content with guaranteed returns are putting money in mutual fund schemes while those with no appetite for interest rate risks are reaching out for fixed maturity plans (FMPs). Meanwhile, investors who want a 'coupon' or a defined return are opting for company fixed deposits. Such investors now have another option - non-convertible debentures.

What is an NCD?:

A non-convertible debenture is a fixed income instrument where the issuer agrees to pay a fixed rate of interest to the investor. The fixedincome instrument cannot be converted into equity of the issuing company and is very different from convertible debentures which can be converted into equity of the issuing company.

There are two types of debentures - secured and unsecured. The debentures with a "charge" on the assets of the issuer are called secured debentures. Put simply, in case of a default by the issuer, the secured debenture holders are paid by selling the assets against which the charge was created. Given the security, you get a lower rate of interest on secured NCDs than their unsecured counterparts. When it comes to NCDs, you may choose from various options, depending upon your needs. If you are someone who's looking for a regular flow of income, you will be better off looking for instruments that pay interest at regular intervals. If you are keen to invest for a longer term, go for the cumulative option where you are paid the interest at the end of a fixed tenure.

Safety:

Investors looking for higher safety can look at secured NCDs. They are a far better option than company fixed deposits, given the charge on the assets of issuer. Of course, you can always consider investing in non-secured debentures to earn extra returns. NCDs are rated by credit rating agencies. Ratings are even more important when it comes to non-secured debentures.

Liquidity:

In the past couple of years, investors have seen NCD issuances from Tata Capital, Shriram Transport Finance and Larsen & Toubro Finance that are listed on the National Stock Exchange. Some of the instruments are fairly liquid, offering a smooth entry and exit to the retail investors.

"Though listing on the stock exchanges aims at providing liquidity, it does not guarantee it," points out an investment banker involved in a listed NCD issuance. It is better to have a look at the trading history of an individual instrument. An instrument that enjoys good liquidity till date may not remain liquid in future. But experts prefer NCDs over company fixed deposits where the investors are absolutely at the mercy of the deposit-accepting company for premature withdrawal of their money.

Returns:

Tata Capital issued NCDs in February 2009 and the rate of interest payable was in the range of 11-12%. The NCD issued by L&T Finance offered a coupon of 9.5-10.24%. If we look at the prevailing yields on these instruments, an investor can still pocket returns in the 9-10% range on some of the NCDs at the prevailing market prices.

Taxation:

Interest accrued on company fixed deposits is added to the income under the head 'income from other sources' and taxed at a marginal rate. There are two ways in which you can earn from a listed NCD - interest and capital appreciation. Interest on NCD is taxed like the interest on a company FD. The highest rate at which interest on both the instruments can be taxed stands at 30.9%.

"If the NCD is listed on a recognised stock exchange and held for at least 12 months before selling, the capital appreciation enjoyed by an investor is taxed as long-term capital gain," says Vikas Vasal, executive director, KPMG. Long-term capital gains are taxed at 10.3% without indexation. Short-term capital gains are taxed at a marginal rate. If the NCD is listed on a stock exchange, there is no deduction of tax at source. Interest payable on company fixed deposits is subject to tax deducted at source.

Investment Strategy:

"As the rate of interest at the long end of the yield curve is expected to come down, it is fairly attractive to lock in money in instruments with a five-year tenure offering a good yield," says Om Ahuja, head - wealth management and strategy at Emkay Global Financial Services. NCDs typically come with a minimum tenure of five years and a maximum term of 10 years.

If you are looking to lock in your money into some fixed income instrument, NCDs are good candidates. NCD prices have also moved in sync with the prevailing rate of interest in the market. For example, Tata Capital's NCD, which pays an annual 12% rate of interest, quotes at 1,172 against the face value of 1,000. This amounts to one interest payout and an appreciation of 17% over almost 18 months. If you expect the rate of interest at the long end of yield curve to go down in the near future, you can go for these instruments to earn interest and enjoy possible capital appreciation. But there's a caveat here, if the rates were to go up in future, the price of the instrument may also fall. If you are not keen to expose yourself to the interest rate risk, better hold on to the instrument till maturity.

You will also have to consider if the NCD has a put and call option. A call option allows the issuer to buy the NCD back at the stipulated date by returning the face value of the bond. A put option allows the investor to surrender the bond in return of the face value at the stipulated date. If the rate of interest were to fall drastically, the issuers are most likely to call back the NCD exercising call options. If you are looking at an NCD as an investment for a couple of years, keep a track of interest rates and financial health of the issuer.