Introduction to NCDs: Part 1

by Manshu on June 29, 2011

in Fixed Deposits

NCDs (Non Convertible Debentures) are in vogue these days, and though I’ve written about company fixed deposits earlier, I see that there are a lot of general questions about them, so here is a post about all the basics of NCDs.

This post contains questions that I see most often, and I was driven to write this because Paresh mentioned some of them yesterday when I asked what type of questions his clients ask about NCDs.

There will at least be a part 2 of this series where I talk about more points, but for the introductory post I wanted to keep things simple and easily digestible.

With that in mind, here are 4 things you must understand about NCDs.

1.  NCDs are debt instruments: Ordinarily, a company can raise money by either issuing shares or taking a loan. There are different ways of taking a loan – they can take a loan from a bank, financial institutions, raise money abroad, or take a loan from the public.

When they take a loan from the public – the instrument used is called a debenture or a bond. Further, there are two types of debentures – Convertible Debentures, and Non Convertible Debentures.

Convertible Debentures can be converted into shares after the lapse of a certain time period, whereas Non Convertible Debentures always remain debt instruments.

Debentures and bonds are used inter – changeably, so keep that in mind as well, and don’t be confused with that.

2. NCDs can be Secured or Unsecured: There are two type of bonds – secured or unsecured. A company can either issue debt that is covered by assets they own, or issue debt that’s like a personal loan, and have no assets marked against it.

A secured NCD is one where they earmark certain assets that will be sold off to pay the bond holders in case of default.

In the case of bankruptcy – secured debt holders will be paid first by selling off the company’s assets. Whatever is left is used to pay off unsecured debt holders, and then whatever is left (which is usually nothing) is given to the shareholders.

That’s why it’s said that secured debt is relatively safer than unsecured debt for bond holders.

3. Your principal is NOT guaranteed in any type of debt: Even if the bond or NCD is secured – that doesn’t guarantee anything.

Sometimes a bond will be issued and secured with 110% assets, which means that the company has earmarked assets worth as much as 110% of the debt issue.

However, the price of the asset may fluctuate and when the time comes to sell the asset the company may be able to recover only 50% of the price of the asset, and hence may not be able to repay your principal.

This is an important point to keep in mind while investing in debt instruments. While safer than equity, there are still no guarantees.

4. How are these different from fixed deposits? Fixed deposits up to a limit of Rs. 1 lakh are guaranteed by the RBI, and RBI pays the deposit holders in case the banks go bust.

Also, while co-operative banks go bust fairly regularly; that fate is not so common for other banks and due to their importance to the financial system, RBI will try to facilitate the takeover of a weak bank, and generally try to avoid a bank going under.

However, these type of efforts will not be spent for most companies, especially the smaller ones.

That’s the reason, generally bank deposits are safer than company deposits.

If you’re making a decision to invest though you will have to dig deeper and not rely on generalities. That’s because there’s a large universe of companies that issue bonds, and you can’t think of bonds issued by Tata Motors in the same manner as you would think of bonds issued by Muthoot Finance.

Conclusion

To summarize, NCDs are debt instruments, they can be secured or unsecured, even when secured, your principal is not guaranteed, and they are different from fixed deposits where RBI insures up to Rs. 1 lakh of your deposit.

I hope these points helped clear some questions you had about NCDs, and as always I eagerly look forward to your questions, comments and observations, and will most probably frame the second part of this series based on them.

{ 26 comments… read them below or add one }

Indian Thoughts June 29, 2011 at 11:06 AM

This post reminded me of my school time where I read about all this. Very basic post, something difficult to find in this fancy world. Passed it on to all my friends. 🙂

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Manshu June 29, 2011 at 4:53 PM

Thanks for passing it along 🙂

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Himanshu Bansal June 30, 2011 at 2:18 AM

Thank you Manshu. This is really a good recap. I will eagerly look for your next post.

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LuvMe February 3, 2012 at 9:28 PM

[…] Now comnig back to REC infrastructure bonds 2011-12. The interest rates of this infrastructure bond is slightly lower than IDFC Infrastructure bond and IFCI Infrastructure bond. However, the interest rate of REC is little higher than PFC infrastructure bond. […]

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Tushar July 1, 2011 at 9:11 AM

Nice post…thanks!

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pratik July 7, 2011 at 1:50 PM

Nice….keep updating about it….Can u please upadate your views before coming up of bonds or NCDs…?

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Manshu July 9, 2011 at 11:39 PM

Thanks Pratik – I’ve written about some of them already like IFCI, Shriram Transport, Muthoot etc. Please feel free to suggest which ones you’d like to see covered, as a lot of the content generated on this site is based on user’s suggestions.

There is a special page for such suggestions here:
http://www.onemint.com/suggest-a-topic/

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AMIT July 13, 2011 at 6:31 PM

Thanks Manshu– It was quiet educative… Please guide us more about SHRIRAM TPT SUBHIKSHA scheme offering 10.5 for 3 years..

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Manshu July 14, 2011 at 5:52 AM

Thanks Amit – I’ll read more about the scheme and do a post on it soon.

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Ravikumar July 17, 2011 at 11:46 AM

Nice post. I always look for such basic posts to expand my knowledge on finance and investments.

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Manshu July 18, 2011 at 3:55 AM

Thanks for your comment Ravi!

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Aditya August 11, 2011 at 5:38 PM

Thanks for the info. Waiting for the second part. Also shed some light on tax implications.

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Manshu August 12, 2011 at 4:47 AM

Thanks for reminding me about this – I had quite forgotten that I had to write a second part 🙂

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khaleel August 11, 2011 at 6:05 PM

nice post manu. Couple of questions. Rbi guarantees fd of banks only or companies also. If i deposit 10lakhs in fd and the bank go bust then rbi will refund me only one lakh?

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Manshu August 12, 2011 at 4:46 AM

RBI only guarantees bank FDs, and that too the limit is Rs. 1 lakh. Company FDs are not covered by them at all.

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Murti Poolla September 19, 2011 at 4:49 PM

If the FY interest on the NCD exceeds Rs 10000, is 10% withheld for INCOME TAX by the Company paying the Interest?

Please explain the Income Tax treatment of NCD?

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Manshu September 19, 2011 at 8:27 PM

No, NCDs that list on an exchange and are in Demat form don’t attract TDS. It’s not tax free, just that there is no TDS on it.

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Murti Poolla September 23, 2011 at 7:39 PM

I understand that NCDs (even in DEMAT form) do attract TDS at applicable Rates and a TDS Certificate is issued. The usual Tax-exemption Certificate is to be filed with the Company to escape TDS

Please refer to page 140 of the RELIGARE FINVEST NCD Prospectus, page 140 and kindly clarify with your vast Scholastic knowledge coupled with rich professional experience.

My high regards for such excellent ‘authentic’ information so freely given to us

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Manshu September 25, 2011 at 9:43 PM

Debt instruments that are listed on a stock exchange and are in Demat form only don’t attract TDS. They are not tax free but just that tax is not deducted on source.

Pg 140 has info on Transfer of NCDs, Electronic Forms, Joint Holders etc. I don’t see any mention on TDS there. What section are you looking at? Just copy paste the lines here and we’ll see what it means.

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Ashok January 21, 2012 at 6:22 PM

Hello Manshu,

Today I got a mild shock ! NCD interest rates are not fixed ?!?!

Background: Tata Capital had issued NCDs in 2009, Jan-Feb period (Did you invest in them ?) . The NCDs were of duration of 5 years (redemption date of Mar 2014). The coupon rates were quite good, between 11-12%. They had the usual monthly/ quarterly/ Annual/ Cumulative options.

Today I got a letter from Tata Capital saying that there will be a General meeting on Feb 15th 2012 with all Bond holders which will “consider” two resolutions:

1. REDUCTION of coupon rate !! They have revised downwards all the coupon rates by 1.5 % effective 6-Mar-2012.

2. Change in Call option – The company can call only the selected NCDs of investors who do not consent for reduced coupon rate (see below).

Now there are four scenarios for the investor :
a. There are a large number of bond holders who will attend the General Meeting on Feb-15 and shoot down this resolution. Highly Unlikely.

The resolutions are passed and :
b. Tata Capital will send you forms where you give a written consent to the revised coupon rate. Stay invested at a lesser yield, and be less happy.
c. Exercise the Put option ( as 3 years have passed since allotment). Redeem the investment.
d. Do not give the written consent. Tata Capital will exercise their call option only for your bonds, and give you back the money forcibly. The NCDs will continue for those who have given consent.

Bottomline, NCD interest/coupon rates are NOT fixed. They can be changed. Did not know this till today.

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Manshu January 21, 2012 at 7:52 PM

Well, this is certainly unusual and I had no idea that it was possible! I came to know about it from your comment and then I Googled up to find an ET article on the same topic.
I browsed through one or two NCD prospectuses that I have and I can’t find anything in there that suggests the company has the power to reduce the interest rate in this manner, but I guess this episode shows that it does.
Very surprised. So now if they reduce the interest rate by 1.5% and it comes down to 9.5% or something – it’s probably better to redeem it right? Since you can get a higher rate in a bank FD and there are some other bonds that are coming to the market as well.

What do you think?

And thanks for sharing.

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Ashok March 13, 2012 at 9:07 AM

The reduced interest rate for the cumulative option is 10.5% (down from 12%). I still plan to continue it for the next two years till maturity. I may or may not get a higher interest for a 2 year deposit/bond but I am too lazy to shop around :-).

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Manshu March 13, 2012 at 4:27 PM

Yeah, 10.5 is fairly good and I guess I would’ve done the same as well.

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santosh March 12, 2012 at 10:20 PM

Dear

Please let me know the process how to transfer the NCD

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Manshu March 13, 2012 at 4:22 AM

You can sell them in the open market if they are listed, otherwise you have to wait to redeem it with the company.

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Roshni July 12, 2013 at 6:48 PM

Nicely explained. Thanks.

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