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Explained: Are non-convertible debentures safe for retail investors?

Several companies have announced public issues to raise funds through non-convertible debentures. How big is the NCD market? What should retail investors look for?

Written by George Mathew , Sandeep Singh | Mumbai, New Delhi |
Updated: December 10, 2021 8:18:10 am
NCDs are debt financial instruments that companies use to raise medium- to long-term capital.

Several companies, including IIFL Home Finance, Indiabulls Housing Finance and Edelweiss Financial Services, have announced public issues to raise funds through non-convertible debentures, offering interest rates between 8.25–9.7%. At a time when fixed deposit rates are in low single digits, these NCD offerings look lucrative.

For retail investors, non-convertible debentures (NCDs) were an attractive source of income until two years ago. However, a spate of defaults in the financial sector in the last three years has made this a risky area now. Still, investors can consider investing in NCDs after evaluating the issuer’s profile.

How big is the NCD market?

NCDs are debt financial instruments that companies use to raise medium- to long-term capital. Fund mobilisation through NCDs had declined in the last two years for several reasons including the impact of Covid-19. Companies raised Rs 10,587 crore through NCDs from retail investors in 2020-21, compared to Rs 14,984 crore in 2019-20, Rs 36,679 in 2018-19, just Rs 5,172 crore in 2017-18, and Rs 29,093 crore in 2016-17, according to Sebi data.

Companies kept away from the market as the pandemic raged in 2020. In fact, NCD issues were on the decline since 2019 after the collapse of IL&FS and the DHFL crisis.

The major players in the NCD market are housing finance companies, gold loan companies and non-banking financial companies (NBFCs) which found it a good avenue for funds with the decline in interest rates in the system. Apart from retail investors, banks, mutual funds and insurance companies also invest in NCDs.

What is the risk due to defaults?

Although NCDs are generally considered safe fixed-income instruments, some recent defaults have made investors cautious. NCDs can be either secured by the issuer company’s assets, or unsecured. Certain issuers, with credit rating below investment grade, had in the past issued both a secured NCD and another unsecured one through the same offer document, with different credit ratings. The risk is high in the case of unsecured NCDs, even though they offer high interest rates.

Credit rating of the issuer is a key factor to consider before investing in any NCD. Defaults of Reliance Capital Ltd have raised concerns among investors, with Rs 16,260 crore worth of NCDs stuck in the company after the RBI superseded it recently. Of this, Rs 15,855 crore are secured NCDs and Rs 1,405 crore unsecured. In the case of DHFL, according to the draft resolution plan released in September, it owes NCD holders (including retail investors, mutual funds and others) Rs 41,431 crore. When the IL&FS collapse happened three years ago, Rs 25,000 crore of NCDs was stuck in the company, which is yet to complete the resolution plan. If a bankruptcy happens, banks have recourse to personal guarantees of promoters, but NCD holders have none.

All these defaults show that even secured NCDs are not safe for investors.

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What should retail investors look for?

At a time when bank FDs are offering interest rates between 5.5–6%, it is easy for investors to get lured into debt instruments offerings 9%.

However, there are a few things that investors need to keep in mind before comparing the two. While bank deposits of up to Rs 5 lakh are insured through deposit insurance, they are also liquid and investors can break them whenever they need funds. But NCDs are not insured, and their liquidity depends on how liquid the paper is and on the market dynamics at that time.

Investment experts say retail investors should follow institutional investors while investing in papers of an issuer. “They should see if a mutual fund has invested in papers issued by that company and if not, then they should consider why MFs have not invested in a high interest yielding paper. They should look at the history of the company and its past issuances and should not just chase returns,” said a fund manager. He said investors must differentiate between papers of different companies and they should go for a lower-interest-yielding NCD issued by a high-quality company rather than a high-interest-yielding paper of a weaker company.

Investment advisors, too, sound a note of caution.

“Investors should remember what happened last year in this space and only go for high quality AAA-rated papers. However, if some investors want to go for higher returns, they should be aware of the risk and be ready to take it. Investments into them should not exceed 5% of the overall portfolio,” said Surya Bhatia, founder, AM Unicorn Professional.

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