Aug 5, 2009

Should You Invest in NCDs?

Photo by pichmiel

Shriram Transport (STCL) NCD issue got oversubscribed many times on day one (July 27, 2009) of the issue. This was the second issue of Non-Convertible Debentures (NCDs) to retail investors by a Non-Banking Finance Company (NBFC). The earlier issue of NCDs by Tata Capital (TCL) in February 2009 had raised 1,500 crore.

Maybe you’re among the lucky few that managed to invest in any of the two NCD issues. Or, it might be possible that you missed both issues and are regretting it now. But don’t worry, there’s going to be many more NCDs issues in the near future. To avoid the last minute rush, it is always better to be properly planned.

This post is going to discuss reasons behind the sudden popularity of NCDs and how to invest in NCDs, should you decide to make them a part of your investment portfolio.

Why there is so much demand for NCDs?
Let’s see the reason for their popularity. At present, Non-convertible debentures (NCDs) are the best debt option to invest in (beyond Section 80C) because of a host of reasons:

1.Better Returns:
Both Tata Capital NCD and Shriram Transport NCD offered interest rates which were quite attractive as compared to interest on other fixed-income options. While yield on redemption of Tata Capital NCD issue was 11.57 –12%, effective yield of Shriram Transport NCD was in the range is in the range of 10.75—11.50% which compares favorably with term deposits (TD) of banks.

If you happen to fall in the highest tax bracket (30.9%), your effective post tax returns will be 7.95 per cent based on rate of interest of 11.50% per annum. And if you’re in the middle tax bracket (20.6%), return after tax will work out to be 9.13 per cent p.a. based on interest rate of 11.50% p.a.

So, right now, NCD seems to be quite attractive investment option among debt instruments given that after-tax returns are around 8% for an investor in the highest tax bracket.

However, in future companies might lower the yield based on the interest rate movement and debt market scenario.


2. No TDS:
Unlike bank FDs or corporate FDs, there is no tax deduction at source (TDS) on NCDs offered in DMAT mode and listed on a stock exchange as per section 193 of the IT Act. However, NCDs allotted to non-resident Indians (NRIs) will be subject to tax deduction at source as per section 195 of the Income Tax Act.


3. Higher Safety:
Unlike corporate FDs which are unsecured, NCD issues by NBFCs are secured debt (NCD’s are 100% secured by assets of the company). Furthermore, both the NCD issues have received good credit rating.

However, this doesn’t guarantee 100% safety. Default risk still remains although very slight. But, default risk remains even in case of Bank FD’s beyond Rs 1lakh.


4. Good Liquidity:
NCDs offer good liquidity due to NSE listing (but listing doesn’t guarantee liquidity). If you would like to go for premature exit, basically you’ve got two options:

a. Sell on the NSE
b. Exercise put option, if available.

However, remember that exiting through secondary market (NSE) entails interest rate risk. If the interest rates fall, the value of NCD will rise (as happened in the case of TATA CAPITAL’s NCDs which were issued in the month of February 2009). And, in an environment of rising interest rates, the value of NCD’s may fall below face value.

But if you plan to hold it till maturity, then there is no-risk due to interest fluctuations.

Furthermore, there is also liquidity risk because, as of now, Indian debt / bond markets are highly illiquid (less frequent trading and insufficient volumes). So, if you plan to encash before maturity by selling on the secondary market (NSE), remember that you might not be able to do so.



How to invest in NCD’s?
If you decide to invest in non-convertible debentures (NCDs), remember the following points:

1.When to Apply:
Apply on the first day of the issue itself because the allotment of NCDs is on first come first serve basis. Chances of issue closing on the first day itself are quite high given the market’s appetite for NCDs.


2. Best NCD Option:
Cumulative option always appear to be most attractive because it offers the highest yield and allows you to reinvest the interest at the same coupon rate / interest rate (i.e., there is no reinvestment risk).

For instance, If you had invested Rs 1 lakh in, say, cumulative option (option 3) of Shriram Transport NCD offering a effective yield of 11.50% p.a. (which was maximum among all the 5 options), you will get pre-tax amount of Rs 1,72,335 at the end of 5 years (assuming Call / Put option shall not be exercised).

On the other hand, if you to would like to receive regular interest income, then you can also look for other NCD options offered such as quarterly, half yearly or annual interest payments, but interest /coupon rate offered is usually lower. And even if the interest / coupon rate is same (e.g. TATA NCD coupon rate was same for annual payment option and cumulative option) you would have to bear re-investment risk, which means that your effective yield can be lower if you’re not able to reinvest your interest income at the same or higher rate of interest (which is highly unlikely).

If you don’t want to lock your money in fixed rate instrument for long term (usually 5 years), you can consider NCD option which is having lower tenure (e.g. 36 months in case of STCL NCD issue), but here the returns are a bit lesser as compared to longest term.

Furthermore, some NCDs also allow staggered redemption; for instance, Shriram Transport NCD Option 1 offering half-yearly interest payment and option 2 offering annual interest payment had provision for staggered redemption (40%, 40%, 20% at the end of 36, 48 and 60 months respectively).


3. Mandatory Requirements:
Before filling the NCDs application forms make sure that you’ve a DMAT account (allotment is compulsorily in dematerialized form) and PAN number (irrespective of amount of application as per SEBI guidelines).


4.Instructions:
Finally, please read instructions carefully because an application form not filled up correctly is liable to be rejected.

Any further question? Please leave it in the comment box.

UPDATE (22 August, 2009): For FAQs regarding taxation of NCDs, comparison with FDs, risks involved in NCDs and stock exchange trading please see part 2: Top 10 FAQs about NCDs.

22 comments:

  1. This is a great post, I appreciate your time and advice

    One Query:
    Can a person apply on his behalf (his PAN+DEMAT)and later transfer the alloted NCDs to his wife (for taxation purposes)?

    I would like to apply for this now and then later transfer it to my wife (once she gets her own DEMAT A/C)?

    ReplyDelete
  2. Yes, of course you can do it, but the very purpose of the transaction will get defeated due to clubbing provisions of section 64(1)(iv) according to which income from NCDs will be taxed in your hands.

    However, if instead of gifting, you sell the NCDs to your wife at market rates, then clubbing provisions u/s 64(1)(iv) won’t be applicable. But then you will be liable to tax on the short term capital gains / long term capital gains as the case may be.

    ReplyDelete
  3. Now that I have applied for the NCDs on my account, is there anyway that I can bring down the taxation impact?

    I should have got a DEMAT on my wife's name; but thats too late now?

    ReplyDelete
  4. No, you can’t escape the tax liability.

    Please also note that if you’re contemplating investing your funds in your wife’s name (rather than out of her own funds), then also tax treatment remains the same.

    So don’t worry.

    ReplyDelete
  5. Well she is a small time teacher at a nearby school and the salary of 7K paid in cash does not get subjected to tax

    If I use up her money can't I return it back by issuing a cheque/cash deposit to her A/C for the NCD buying on her name?

    I have applied for the STFC NCDs and making my mind to sell these off on allotment, if I see a good positive on listing, would this be a good proposition?

    ReplyDelete
  6. Please don’t get confused. Think coolly. First understand what I’ve already answered before asking any further questions.

    ReplyDelete
  7. Dear Mr. Fisher,

    If I buy a NCD from the exchange today what will be the tax treatment of my interest income and what about the capital loss I will suffer due to high market price.

    Regards/Ramesh

    ReplyDelete
  8. Tax treatment of interest income remains same irrespective of whether you buy directly from issuing company or from the secondary market.

    As regards capital losses suffered by you due to buying the NCDs at a higher price in the market, I’m not yet clear from tax point of view that whether or not capital gains/losses can arise on final redemption of NCDs by the company.

    ReplyDelete
  9. As a senior citizen, recently I invested Rs 5 Lakhs in SCSS 9% post office savings. But now I feel that I should I invested in NCD where the interest rate is better. Some of my banks FDs are maturing soon. Please suggest some NCDs where I can get regular qtrly/half yearly interest in my DEMAT a/c. Regards, veru_111@yahoo.co.in

    ReplyDelete
  10. During 2009, there has been 3 issues of NCDs, the first one was by TATA Capital (TCL) in February 2009, second was by Shriram Transport Finance (STFL) in July 2009.

    The latest one is by L&T Finance which is currently open for subscription. Out of the four investment options offered by L&T Finance NCD, first one is offering coupon / interest rate of 9.51% p.a. payable quarterly for 5 years and second one is offering semi-annual (half-yearly) interest payment with a coupon rate of 9.62% p.a. for 5 years. If you want to lock-in your returns for a longer duration then go for option 4 which is 10-yr NCD offering a coupon rate of 10.24% p.a. payable half-yearly (with a YTM of 10.50%). In my view, option 4 is best for you.

    You can also buy the NCDs from the stock exchange. TATA Capital NCD is listed on both BSE as well as NSE. The Shriram Transport NCD is also going to be listed on the NSE very soon. For more details, please see “NCDs – Top 10 FAQs” and “L&T Finance NCD – A Review.” Link to both the posts is provided at the end of the post just above the comment section.

    ReplyDelete
  11. Great article. I am planning to buy Tata Fin NCD through secondary market. Though available with little premium I want to divert funds from bank cd's which return very low yield due to low interest and taxed at 33% at source.
    As per latest tax information, the long term capital gains tax is nil if held for more than one year. In that case if I invest in a cumulative scheme (hold for more than a year) I am not taxed at all, right?

    ReplyDelete
  12. Shiva, LTCGs from NCDs are not exempt from tax, but taxable at a concessional rate of tax u/s 112. (For details, see ‘NCDs: Top 10 FAQs’).

    However, at this moment you can’t say for sure that you’ll have capital gains. Capital gains or loss will depend upon the market interest rate movements. In case, if in the future the interest rates go up then you might have to incur capital losses.

    Secondly, also remember that though there is no TDS, interest income from NCDs is fully taxable at the maximum marginal rate applicable to you.

    ReplyDelete
  13. Suppose a person X, holds the NCD for a whole yr, but sells it to Y, just before the interest payment day. Then who is entitled for the interest ? Please inform us the interest payment record dates for some NCDs in near future, because I am thinking of buying some NCDs.

    ReplyDelete
  14. In the example mentioned by you X, will be entitled for the interest.

    For your reference purpose, I’m citing the relevant clauses from prospectus of Tata Capital NCDs:

    1. Payment of interest will be made to those NCD holders whose name appears in the register of NCD holders as on the record date.

    2. The record date for payment of interest shall be 15 days prior to the date on which interest is due or payable.

    3. For NCDs subscribed under option 1, interest will be paid on first day of every month; for NCDs subscribed under option 2, interest will be paid on the first date of June, September, December and March every year; and for NCDs subscribed under option 3, interest will be paid on first day of March every year.

    Similarly, you can refer the prospectus of other companies issuing NCDs.

    ReplyDelete
  15. IF I purchase TATA NCD Qtly Int Payment from Stock Market so do they pay me interest on qtly basis
    Can i sell this NCD whenever I want

    ReplyDelete
  16. Amit: Yes, you're correct. You'll get qtly interest and can sell whenever you want.

    ReplyDelete
  17. Hi Mr. Fisher
    Can I invest in NCDs in a SIP type format - meaning investing (little amounts) on a monthly/quarterly basis?

    regards

    ReplyDelete
  18. Machax,

    Yes, it is very much possible.

    ReplyDelete
  19. Hi Mr. Fisher
    Appreciate your prompt reply. Continuing the earlier question, which is better, the SIP type route or bulk investments for NCDs?

    regards,

    ReplyDelete
  20. Machax,

    Very difficult question!! See, as you might know that investing in NCDs involves interest rate risk. Due to declining interest rates in 2009, prices of listed NCDs rose substantially. You can compare the current market price of listed NCDs (Tata Capital NCDs & Shriram Transport NCDs) with their face values and see the returns. Also compare the maximum YTM offered by Tata Capital NCD with the latest 2nd NCD offer from L&T and notice the declining trend in interest rate.

    However, now the market indicators point towards increasing interest rate regime and consequently in the near future the market value of NCDs may decline, adversely affecting your returns.

    So, decide accordingly keeping in mind the above consideration.

    ReplyDelete
  21. I subscribed to NCD's of STFC and L&T thru icicidirect well now I need money urgently and am finding redemption process extreemly frustrating. Icicidirect when I contacted them for instructions all they have provided is a tel number in Mumbai one for each co that no one answers !
    Could you please advice.

    ReplyDelete
  22. Hi Fisher
    Last week Tata NCD sent me an email stating they have reduced the coupon rates based on a decision taken by 'NCD Holders' at a meeting held by Tata Capital. They've reduced the rates for all four options by 1.5% for Options II, III & IV and 1.25% for Option I. I was under the impression that the coupon rates are to remain the same till maturity. Also Tata NCD has given the choice for either continuing with the NCD till maturity or redeem the same before a certain date. They also state that trading in Tata NCDs is being discontinued. I've queried them regarding the legality of this but they are yet to reply to my email. Any idea if this follows the scheme of things for NCDs?

    regards,

    ReplyDelete

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