Investors should avoid NCDs rated below AA despite mouthwatering returns

Diversify across sectors and match your investment horizon with paper's tenor to avoid liquidity issues

Non-convertible debentures (NCDs) from a number of companies — IIFL Finance, Muthoot Fincorp, Edelweiss Financial Services, Indiabulls Commercial Credit and InCred Financial Services — have hit the markets in recent times.  

Why invest in them?
 

While the State Bank of India is offering 6.25 per cent on its five-year fixed deposit (FD), NCDs could offer you as much as 8.75-10.03 per cent over the same period.
 

“After the continuous repo rate hikes by the Reserve Bank of India (RBI) in the last five policy meets, investors should take advantage of the higher spreads in credit papers. Once institutional demand for NCDs perks up, spreads could shrink. Investors may get an opportunity to encash their gains or stay invested at elevated yields,” says Ajay Manglunia, managing director and head of investment grade group, JM Financial.
 

While NCDs offer higher returns, investors need to also assess their risks.

Factor in credit risk
 

Credit risk is the possibility of default or late payment of interest and principal. An NCD’s credit rating will tell you whether this possibility is high or low. Instruments rated below AA are regarded as high-risk.
 

While most banks and housing finance companies’ (HFCs) FDs come with AAA rating, many NCDs have lower ratings.

“Credit quality, as gauged by credit rating, is paramount. Apart from credit rating, the issuer’s goodwill, the track record of its past issuances, and years of existence of the company should be taken into account while deciding,” says Joydeep Sen, author and corporate trainer (debt).
 

Adds Manglunia: “As a general rule, you should stick to higher-rated NCDs for safety.” He adds that investors may consider lower-rated NCDs for their higher returns, but only if they have done adequate due diligence.

Watch out for reinvestment risk

Reinvestment risk refers to the inability of the investor to reinvest the money received at maturity in another instrument offering a similarly high rate. This risk arises if interest rates within the economy have come down since the last investment. This is a risk that investors could face if they invest currently for the medium term.  

NCDs are also subject to interest-rate risk — the risk of prices falling due to increase in interest rates. Currently, we are approaching the end of the rate hike cycle, so investors may not be exposed to interest-rate risk if they have a medium-term horizon. Rather, they may see bond prices appreciate over the next couple of years if rates fall.

Consider liquidity needs

Bank and corporate FDs allow premature withdrawal after paying a penalty. To exit an NCD, investors need to sell them on the stock exchanges where they are listed. As liquidity tends to be low, finding a buyer at fair value within a short period may prove difficult.
 

 “Liquidity is an issue, especially in lower-rated bonds. It can take a few days to liquidate them. AAA-rated NCDs are generally more liquid,” says Vikram Dalal, managing director, Synergee Capital Services.

Spread your risks

One step you can take to reduce credit risk is to build a diversified portfolio of issuers belonging to a cross section of industries. Don’t allocate more than 10 per cent of your capital to one issuer. Besides credit rating, study the company’s financial statements and avoid over-leveraged players.

To circumvent reinvestment risk, ladder your investments. To deal with liquidity risk, match your investment horizon with the NCD's tenure.
 

While NCDs offer higher interest rates for longer tenures, stick to short-term or medium-term papers only. Investing for a longer tenure means you run a greater risk of suffering due to deterioration in the company’s finances.

Keep in mind post-tax yield
 

The interest paid by NCDs is added to income and taxed at slab rate. Investors in higher tax brackets need to consider the post-tax returns of these instruments.
 

High-income investors may be better off in debt mutual funds where they would get indexation benefits after three years. “They should opt for target maturity funds with residual maturity of three-four years where the post-tax yield will be around 6.65

per cent,” says Dalal.

Strike a balance between risk and reward

• A 5-10-year fixed deposit from State Bank of India is currently offering 6.25 per cent
• A five-year NCD (rated AA or AA-) is currently offering 8.5-10.3 per cent
• Higher returns are usually accompanied by higher risk
• Most NCDs launched recently have a credit rating of AA or AA-
• It is safer to not invest in a paper below AA rating
• Invest in lower-rated papers only if you have done your research and are confident the company won’t default
• Even in that case, limit your exposure to lower-rated papers