Before we get down to the nitty-gritty of Non-Convertible Debentures, let me ask you a simple question. In fact, you should ask this question to yourself. How much of a difference would this 1%-2% extra returns (in non-convertible debentures) make in your life?
If I ask you what is a debenture, would you be able to answer this question? According to most people, it is a corporate FD, anyways, let it be like that. I will explain about debentures in the latter part of the article.
I am sure you are not going to invest your entire amount in this NCD. Nonetheless, if you are planning to invest the entire amount, it would be the biggest mistake of your life. Let me take an example to help you understand why.
Suppose you want to invest 10% of your debt investments in NCD, let us assume that 10% to be 5 Lakhs.
Now, if you invest that 5 Lakhs in a Bank FD at 7% rate of returns, the maturity value would be 5.35 Lakhs. And if you invest the same amount in a corporate FD offering 9% returns, the maturity value would be 5.45 Lakhs.
The difference of 10,000 and assuming 30% tax on this 10,000, the net gain would be around 7,000.
For this meager gain of 7,000, you could be putting your entire capital of 5 Lakhs at risk. But Why?
Because if the company defaults, you will not get anything. Do you remember the case of DHFL? People are still struggling to get their money back.
Non-Convertible Debentures are not as secure as FDs. You can argue that even a bank can default, yes of course it can. But what are the chances of a bank defaulting in comparison to an individual company? Do I even need to answer that question?
Always remember – Return of capital is more important than return on capital.
And if you actually calculate, you will find out that these returns are nothing but tiny little peanuts.
Also Read: 4 Unusual ways of saving tax
So What Exactly Are Debentures?
When a company wants to raise money, they usually have two options – equity or debt. Equity implies giving a share of the company to the lender. But it gives them the advantage of not having to make a fixed payment. Debt implies making fixed payments, but not giving a share of the company to the lender. A business owner who does not feel like sharing the company (the fancy corporate word is – equity dilution) would go for debt.
Under various forms of debt, the most prominent one is something called a debenture or bond issue. The terms are often used interchangeably, but the word bond is usually used for government debt. So for the sake of simplicity, let us stick to the term debenture here. Coming back to our story, a company would raise money through debt when they do not want to face equity dilution. The general public, you, me, my far off relatives, etc., can all buy this debenture. Moreover, the company guarantees a fixed return in most cases.
Is The Risk Low And Return High?
The risk of losing the invested principal amount is lower than subscribing to the equity of a company. But the risk is much higher than a bank FD. You get a fixed return when you buy a debenture. As in the event of the company going for liquidation, the lenders of the company gets the first charge on company assets. Then, the debenture holders and equity investors get the fag end of the deal.
Compared to an FD, or fixed deposit, the risk is higher, considering the issuing authorities which in this case are not banks. While banks are safer since they are regulated by the super-efficient Reserve Bank of India, that isn’t always the case with corporate. There have been numerous cases of debt defaults, debt restructuring, etc., where the debenture holder doesn’t really get the deal he wants. So yes, the risk is definitely higher when you hold debentures.
So, what is that nasty word before debenture? What is so ‘non-convertible’ about it?
Well, there are two types of debentures in general. You have debentures that get converted to equity after a certain passage of time, let’s say 10 years. You also have debentures that do not get converted but are mandatorily redeemed back to you after the same time period of 10 years. The former is called a convertible debenture, because the debenture gets converted into equity. The latter is called a non-convertible debenture because you do not get the option of conversion.
Let us look at a quick example of how this all works.
Let’s assume Mr. A buys a 10% convertible debenture in Reliance and a 10% non-convertible debenture in Wipro. The terms in the convertible debenture mandate conversion into 10 units of equity after 5 years. He buys the debentures for 100 Rs. For 5 years. Mr A would get the interest as coupon payment on both debentures: Reliance and Wipro. After 5 years, Reliance will give 10 units of stock to MR A instead of the principal value. The Wipro folks would return the invested principal amount back to him.
Look at it like putting an FD into the bank. The FD interest gets credited into your account on a yearly basis. When the FD is about to mature, the bank gives you your principal amount back. That is akin to a non-convertible debenture. However, if the bank offers you its shares instead, that would be like a convertible debenture.
How Do We Know Which Company Is Good and Which Is Bad? Whose Debentures Should I Buy?
The most time-tested way to choose a company for purchasing debentures is by taking a look at its credit rating. Various credit rating agencies monitor companies that issue debt. Additionally, the agencies rate their ability to repay this debt, as well as the interest. They do this through various models, finding out how efficient they are at running their business, their credit history, etc. Look at this as mini-CIBIL ratings for these companies. Some of the well-known credit rating agencies in the Indian market are CRISIL, ICRA, CARE, etc. A debt rating of AAA is generally said to be top-quality debt, while anything below BB- is considered below investment grade.
Debentures can either be secured or unsecured. A secured debenture is backed by tangible assets in the company whereas an unsecured debenture is not. For example, suppose you do not get your coupon payment on time, and have a secured debenture. You will have the right to demand the sale of the secured company assets to realize your coupon payment. However, you will not be allowed to do the same if it is an unsecured debenture.
A callable debenture is one where the company has the option of repaying your principal and canceling your debenture. Even before the entire tenure gets completed. A puttable debenture gives you, as a debenture holder, the right to sell this back to the company. Therefore, you can sell it back any time you feel it is getting too risky for you.
Taxation On Debentures
Hold Till Maturity – Interest from NCDs is clubbed into your income and taxed as per your tax slab.
So, before you think of purchasing non-convertible debentures, always remember – Return of capital is more important than return on capital.