Check credit rating, financials before investing in NCDs

These instruments should not constitute more than 20% of your debt portfolio; do your homework before getting in

With non-banking financial companies (NBFCs) finding it difficult to raise funds from banks, total issuance of nonconvertible debentures (NCDs) from them this financial year is expected to cross the previous high, according to ICRA Ratings. In 2013-14, they raised a record ~423.83 billion. With recent issues like those of DHFL and JM

Financial promising annual returns of nine per cent and above, investors are likely to be attracted to these. However, they should not invest in these without proper due diligence.

After returns, the next thing investors should check is the issuer's credit quality. “Safety lies in investing in a company with a credit rating of AAA. But, if you wish to take some risk in pursuit of higher returns, you may go up to AA,” says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi (Securities and Exchange Board of India)-registered investment adviser (RIA).

The reason he cites for sticking to highest-grade papers is that credit ratings in India can fall by multiple notches at one go. Raghaw recommends sticking to NCDs of established companies for which the reputational risk of a default would be high. An alternative way to take exposure in NCDs is by investing in credit risk funds. These funds invest in papers below AA rating as well but the risks they take are backed by a lot of research.

At the time of investing, and even after, keep a close eye on the company's financials, especially its level of leverage. "A company may promise you a “nine per cent-plus return today but if its financials deteriorate after a couple of years, you might not even get your principal back,” says Mumbai-based financial planner Arnav Pandya. He suggests investors should not lock themselves in NCDs of more than three to

five years.

Monthly, quarterly, six-monthly and yearly payout options are available. “If you take your payouts at longer intervals, the rate of return will be higher because of the compounding effect,” says Pandya.

The rate of return promised to you should be the compounded annual rate. "Many companies do fraudulent math to promise you a higher rate," says Raghaw. Suppose you invested ~100,000 and you

get ~153,862 after five years. The compounded annual return is nine per cent. But, the company could advertise that it is paying a return of 10.77 per cent (~53,862 is the total interest; when this is divided by five, the number of years, you arrive at 10.77 per cent). Be wary of such tricks.

Do not load your debt portfolio too much with NCDs. "Companies offer a higher rate of return on NCDs because they are unable to borrow from other sources at a lower rate, owing to the credit risk they carry. These should not constitute more than 15-20 per cent of your debt portfolio,” says Pandya.

Finally, consider the alternatives available. Bank fixed deposit (FD) rates are rising. The three-year FD rate from State Bank of India is 6.70 per cent, while some banks like DCB are offering as much as 7.75 per cent. Moreover, the interest income you get from an NCD will be taxable at your marginal tax rate.

“A person who doesn’t need a regular income might be better off investing in a debt fund where he will be eligible for indexation benefit after three years," says Raghaw. The GoI Saving Bond, which offers 7.75 per cent, is another option. Senior citizens should give priority to government schemes with zero default risk like Senior Citizens Savings Scheme (8.3 per cent annual return and Section 80C tax benefit) and Pradhan Mantri Vaya Vandana Yojana (8-8.3 per cent annual return).