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.Â 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.
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.