Safe if held till maturity

What are NCDs?

NCD is the acronym for Non-Convertible Debenture. To understand NCDs,we must first understand what debentures are. A debenture is like a bond. It is a certificate which states that the company will pay the investor a certain sum of money. This payment consists of interest payment on the principal and return of capital on maturity.

Debentures are broadly of three types. The first type is a “fully convertible” debenture. This is a debenture that pays the investor interest initially. Subsequently,after a stated period of time,it converts to one or more equity shares of the company. No principal is returned to the investor in this case. Instead the investor becomes a shareholder of the company.

The second type is a “non-convertible” debenture. As the name implies,this debenture does not convert to equity shares. It returns the principal amount to the investor on maturity.

The third type is a “partially convertible” debenture,which upon maturity returns part of the principal along with some equity shares.

There have been a number of NCD issues in recent times,such as the ones from Tata Capital,L&T Finance,etc. These debentures are secured by a claim on the immovable property owned by the company.

“I have understood what an NCD is,but there seem to be various options within NCDs. What are the implications of each of these?” enquired Satish.

NCD options

“That is correct,” I replied. The two main options offered by NCDs are the cumulative option and the regular-interest option. In the cumulative option,interest is paid only at maturity along with the principal amount. No payments are made before that. On the other hand,the regular-interest option pays investors interest periodically. The periodicity could be quarterly,

annually,etc.

“If I decide to invest in an NCD,should I choose the annual interest option?” queried Satish.

“Not necessarily,” I replied. “If you need funds on a regular basis to meet your living expenses,then the regular income option is suitable. If not,and you are investing for the long term,then the cumulative option is preferable. This option is often more tax

efficient,” I said.

Advantages of NCDs

On hearing the words “tax efficient”,Satish perked up. “How is the cumulative option more tax efficient than the other?” he asked.

If held to maturity,the income from the NCD is liable to long-term capital gains tax at 10 per cent. In the regular interest option,the interest received is taxed at your marginal tax rate. So if you are in the 30 per cent tax bracket it is better to use the cumulative option. However,if you are not taxable or in the 10 per cent bracket you could choose either option.

“Do NCDs have any other advantages?” he asked.

“Yes,there are some other advantages,” I said. First,there is no TDS. This means that interest payments from NCDs do not suffer Tax Deduction at Source (TDS). So if your income is non-taxable you do not have to wait for a refund of the TDS deducted.

Second,since NCDs are listed on the stock exchange you can encash them in an emergency.

“Why only in an emergency? Can’t I get my principal back by selling the NCD anytime?” asked Satish. “That’s not guaranteed,” I replied. It depends on how interest rates in the economy have moved since the allotment of the NCDs. If interest rates have remained the same,you will receive the principal you have invested; if they have risen,you will receive less than what you invested; and if rates have fallen,you will be able to sell the NCD at a higher price. This is because the sale price is determined by the market based upon prevailing

interest rates.

“So there is a fair chance that once I have invested I am stuck till maturity?” he asked.

“Not exactly,” I said. Many NCDs offer a “put” option to the investor. A put option essentially allows the investor to sell the NCD back to the company at a predetermined date. This option can usually be exercised once or twice during the tenure of the NCD and is stated during the public offering. Satish glanced at the form in his hand and seemed to nod,as though he had found the put option offered.

He then said,“It appears to me that NCDs offer a slightly higher interest rate,have tax advantages such as no TDS,and lower taxation in the cumulative option. But the liquidity is less than in a bank fixed deposit.”

“That is correct,but always check the credit quality of the issuer before investing,” I replied. Satish waved goodbye and left.

The author,a CFP,is chief executive of Sardesai Finance.

Email: ceo@sardesai.com