What are Non-Convertible Debentures (NCDs)

Non-convertible debentures (NCDs) represent a key financial instrument utilised by esteemed corporations to secure long-term capital. Issued through public offerings by high-rated companies, NCDs are distinct in their inability to convert into equity or stocks.

What are debentures?

Debentures, in a broader financial context, represent debt instruments issued by corporations or governments to raise capital. They serve as a means for these entities to borrow funds from the public or institutional investors, promising to repay the principal amount along with interest at predetermined intervals.

Debentures come in various forms, and one significant category is non-convertible debentures (NCDs), which, as the name suggests, cannot be converted into equity shares. This article focuses on unraveling the intricacies of NCDs, examining their features, benefits, and considerations for potential investors.

What are non-convertible debentures?

Non-convertible debentures (NCDs) are fixed-income instruments that are usually issued by high-rated companies in the form of a public issue to accumulate long-term capital appreciation. They are a type of debt instrument that cannot be converted into equity or stocks. NCDs have a fixed maturity date and the interest can be paid along with the principal amount either monthly, quarterly, or annually depending on the fixed tenure specified. They offer relatively higher interest rates when compared to convertible debentures.

NCDs are backed by the creditworthiness of the issuer and are not backed by any collateral. Interest pay-outs are either monthly, quarterly, half-yearly, or annually. NCDs do offer a cumulative payout option as well.

Investors should consider the credit rating of the issuer before investing in NCDs. Companies are ranked by credit rating agencies such as CRISIL, CARE, etc. A higher credit rating means that the company has the ability to fulfil credit obligations. However, a low credit rating means that the company has high credit risks involved. If any issuing company fails to make payments, then the rating agencies give them a lesser ranking.

Features of non-convertible debentures

1. Credit rating: Credit rating agencies such as CRISIL, CARE, etc., rank companies based on their creditworthiness. A higher credit rating means that the company has the ability to fulfil credit obligations. However, a low credit rating means that the company has high credit risks involved. If any issuing company fails to make payments, then the rating agencies give them a lesser ranking.
2. Interest: NCDs have a fixed maturity date and the interest can be paid along with the principal amount either monthly, quarterly, or annually depending on the fixed tenure specified. They offer relatively higher interest rates when compared to convertible debentures. Interest payouts are either monthly, quarterly, half-yearly, or annually. NCDs do offer a cumulative payout option as well. Moreover, unsecured NCDs can offer a higher interest rate.
3. Issuance: NCDs are made available to investors through open-market public issues conducted by companies within defined periods. Interested investors can purchase these debentures during the specified timeframe, contributing to the company's capital-raising efforts.
4. Tradable securities: Non-Convertible Debentures are actively traded in the stock market. This tradability provides investors with the flexibility to buy or sell NCDs in the secondary market, enhancing market liquidity and allowing investors to manage their portfolios dynamically.
5. Credit rating: Given that NCDs lack collateral backing, only companies with robust credit ratings can issue them. These credit ratings, regularly assessed by credit rating agencies, serve as a crucial determinant of an issuer's ability to fulfill credit obligations. This underscores the importance of creditworthiness in the issuance and investment in non-convertible debentures.

Types of NCDs

There are two types of non-convertible debentures:

1. Secured NCDs:

Secured non-convertible debentures are a type of debt instrument where the issuer provides specific assets as collateral to secure the investment made by the debenture holders. In the event of a default by the issuer, the debenture holders have a claim on the specified assets pledged as collateral. This added layer of security makes secured NCDs less risky compared to unsecured counterparts.

Key features:

• Collateralised security: Secured NCDs are backed by tangible assets, such as properties, plants and machinery, or any other specified assets, which provide a safety net for investors.
• Lower risk: The presence of collateral reduces the risk for investors, as they have a claim on the underlying assets in case of default.

Investor considerations:

• Investors often find secured NCDs attractive due to the lower risk associated with the presence of collateral.
• Interest rates on secured NCDs may be slightly lower than those on unsecured NCDs, reflecting the reduced risk for investors.

2. Unsecured NCDs:

Unsecured non-convertible debentures do not have any specific assets pledged as collateral. Investors in unsecured NCDs rely solely on the creditworthiness and repayment capacity of the issuing corporation.

Key features:

• No collateral: Unsecured NCDs lack the backing of specific assets, making them riskier compared to secured NCDs.
• Higher risk-reward profile: Due to the absence of collateral, unsecured NCDs generally offer higher interest rates to compensate investors for the increased risk.

Investor considerations:

• Investors seeking potentially higher returns may be attracted to unsecured NCDs, but they should be aware of the higher risk involved.
• Credit rating assessments become crucial for investors in unsecured NCDs, as they rely heavily on the financial health and creditworthiness of the issuing corporation.

The choice between secured and unsecured NCDs depends on an investor's risk tolerance, return expectations, and the level of security they seek in their investment portfolio. It is essential for investors to conduct thorough due diligence, including assessing the credit rating of the issuing corporation, before making investment decisions in the Indian securities market.

Things an investor should consider before investing in NCDs

Level of debt

The level of debt of the issuing company is an important factor to consider. If the company has a high level of debt, it may not be able to service its debt obligations in the future. Therefore, it is important to check the debt-to-equity ratio of the company before investing in its NCDs.

Capital adequacy ratio (CAR)

CAR is a measure of a bank’s capital in relation to its risk-weighted assets. It is an important indicator of a bank’s financial strength and stability. A higher CAR indicates that the bank has a strong capital base and is better equipped to absorb losses. Therefore, it is important to check the CAR of the issuing bank before investing in its NCDs.

Provisions for non-performing assets

Non-performing assets (NPAs) are loans or advances that are in default or are in arrears. It is important to check the provisions made by the issuing company for NPAs. Higher provisions indicate that the company is better prepared to handle NPAs.

Interest coverage ratio

Interest coverage ratio (ICR) is a measure of a company’s ability to meet its interest obligations. It is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expense. A higher ICR indicates that the company is better equipped to service its debt obligations. Therefore, it is important to check the ICR of the issuing company before investing in its NCDs.

Corporate fixed deposits vs. non-convertible debentures

Conclusion

Non-convertible debentures (NCDs) offer investors a fixed-income avenue with varying risk profiles. Whether you opt for secured or unsecured NCDs, it is crucial to conduct thorough research and understand the features and risks associated with each type. Diversification, careful assessment of credit ratings, and staying informed about market conditions are key elements for making informed investment decisions. As with any investment, it is advisable to consult with financial advisers to tailor your NCD investments to your financial goals and risk tolerance. By incorporating these tips into your investment strategy, you can make well-informed decisions and potentially enhance the overall stability and returns of your investment portfolio