Everything about Non-convertible Debentures Explained

Businesses need funds for proper growth and development. Big and established businesses issue a financial instrument called debentures to raise funds at a fixed rate of interest from investors. There are different types of debentures, namely convertible and non-convertible.

This piece enumerates the important details related to Non-convertible Debentures. Read on.

Non-convertible Debentures are debt instruments that cannot be converted to equity or stocks by the investor. Generally, these monetary instruments are issued by big companies. They are fixed sources of income with a fixed duration and interest rates. Investors receive the principal amount with interest.

These debentures are not backed by any collateral. So, investors consider the issuer’s creditworthiness while making any investment-related decisions. This is why credit rating agencies' ratings play such an important role. These ratings reflect the issuer’s reliability.

The features of non-convertible debentures are as follows:

1. Interest Rate

A non-convertible debenture generally has a fixed rate of interest which has an inverse relationship with the issuer’s creditworthiness. NCD, with a high credit rating, has a low-interest rate.

2. Credit Rating

Credit rating agencies like CRISIL, CARE and ICRA issue ratings of big businesses. It reflects the history of creditworthiness and the future potential of fulfilling credit obligations. A low credit rating indicates that the company has a high credit risk. Companies that have a good rating score can issue debentures. Moreover, credit rating agencies regularly rate NCDs.

3. Taxation

If an investor decides to sell an NCD within 3 years, Income Tax Department will consider it as a Short Term Capital Gain (STCG), and it will be subject to applicable tax. If the investor decides to sell off the NCD after 36 months, then IT officials will deem it Long Term Capital Gain (LTCG), and it will attract applicable tax.

4. Tenure

Based on their financial objectives, investors can choose short-term or long-term NCDs. These debentures are quite flexible. The minimum tenure happens to be 90 days, while the maximum tenure happens to be 10 years.

5. Return Rate

NCDs earn returns in two ways. These two ways are interest-based or growth-based and cumulative opportunities. Secured NCDs are less risky because a company’s assets secure them.

The details of the two types of Non-convertible Debentures are as follows:

1. Secured Non-convertible Debenture

A business's assets firmly back these NCDs. If the company fails to make timely payments, investors can liquidate the business's assets and recover their money.

2. Unsecured Non-convertible Debenture

A company's assets don't back these NCDs. They are based on the issuer's creditworthiness. The rate of interest for unsecured NCDs is higher than for secured ones. Moreover, if a business sees bad days, investors of unsecured NCDs need to wait to receive their payment. In simpler words, a company pays unsecured NCD holders only after paying secured NCD holders.

The benefits of NCDs are as follows: 

• Liquidity

Non-convertible Debentures are listed and traded in the stock market, so they have high liquidity. This feature of NCDs is important as it helps investors arrange cash in emergencies.

• Diversification

Investing in NCDs will ensure diversification in the investor’s portfolio. It will also provide income security.

• No Provision of Upfront Tax

As per the regulation of Section 193 of the Income Tax Act, there is no TDS (Tax Deducted at Source) with respect to securities issued by any company. But, Section 195 of ITA states that NCDs of Non-Resident Indians (NRIs) will be subject to TDS.

• Capital Appreciation

NCDs are listed on the stock exchanges. So they can benefit from the fluctuations of the stock market. They might have a capital appreciation as well.

• Options of Interest Payout

There are various interest payout options that come with NCDs, namely quarterly, monthly, half-yearly and annual interest payments options.

The limitations of these debentures are as follows:

• One cannot convert Non-convertible Debentures into equity shares of a company.
• Issuers with low credit ratings often issue NCDs at high interest. But these companies can default on payments upon maturity.
• If a company faces financial trouble, it first focuses on paying its secured creditors. So, unsecured debenture holders need to wait to receive their money.
• Unsecured NCD-holders are at risk of not receiving the principal amount and interest.

Enumerated below are the important tips for investing in NCD:

• Investing in NCDs from one particular sector isn’t a safe option. Portfolio diversification, i.e. investing across different sectors and periods, can considerably reduce risk exposure.
• One should minutely read the associated terms and conditions. This is because corporates use NCDs to raise funds to meet a specific business purpose. One should refrain from investing if they don’t receive adequate clarity on how their money is to be used.
• Past results have shown that NCDs from secondary markets have generated higher returns. This is particularly applicable when one buys old NCDs at a time when the corporate issues newer ones.
• When the NCD interest rate is due, the ideal trading time for a Non-convertible Debenture happens. This is the time when one can expect to earn profits.
• However, one should note that it isn’t advisable to go for an NCD based on only the interest rate. It is the NCD yield that determines the real return.

Given below is the list of factors that investors should consider with respect to investing in NCDs:

• Level of Debt

One should thoroughly check the business's asset quality before investing. It is not a good idea to invest if the business allots 50% of its assets for unsecured loans.

• Issuer’s Credit Rating

This parameter reflects a business’s financial position and potential. It computes the business’s ability to raise funds from internal and external operations. It also calculates a business’s financial sustainability. Investors should opt for a company with an AA rating.

• Capital Adequacy Ratio (CAR)

This parameter assesses the capital assets of a business and checks whether the business has enough funds to withstand financial losses. Investors should invest their money in a business with a history of maintaining a minimum of 15% CAR.

• Interest Coverage Ratio

One needs to check this parameter before investing in NCDs because it throws light upon the business’s ability to settle the interests on loans at any time.

To sum up, this blog has enumerated the important details of Non-convertible Debentures. It provides its features and benefits. It also shows its limitations. Additionally, it elucidates important suggestions and the things one needs to consider before investing in NCDs for the convenience of readers.