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Why retail investors should approach NCDs with caution right now?

Corporate bonds are not immune to economic slowdowns, inflation and flailing stock prices. In fact, recent reports indicate that the private debt market is stuttering and staring at some of the worst growth rates in the last ten years. With liquidity from mutual funds drying up, corporates are opening subscriptions for Non-Convertible Debentures or NCDs in an attempt to leverage the retail investment sector. Nevertheless, with an uncertain debt market plagued by occurrences of defaults, the question of whether you should consider an NCD is more pertinent now than ever before.

Here’s why you, a retail investor, should be extra cautious when approaching NCDs.

Debentures, even non-convertible ones, carry risk
While it’s true that NCDs do not carry the same levels of risk as their convertible counterparts, as the latter expose your investment to the equity market, NCDs still make you vulnerable to both default and capital loss. Basically, when a company’s liquidity levels run low, it may resort to delaying the promised interest payments. However, the problem runs deeper as defaults reveal a shaky financial position and if this results in a downgrade, the price of the bond can go downhill as well. In other words, you should know that capital losses are a very real part and parcel of investing in an NCD.

Higher returns act as bait but secondary market prices serve a reality check
Recent NCD subscriptions promise attractive returns with coupon rates ranging from 9% to around 10.5%. Nevertheless, caution is key here, especially if the programme has a credit rating of less than AAA from a reputed agency. As an investor, you should sound the warning bells when you come across NCDs being quoted in the secondary market at a discounted rate. This is especially true when you account for the fact that price erosion is not something you regularly expect from the debt component of your investment mix. So, while NCDs promise high interest rates, around 10%, you shouldn't be subscribing to them if it involves settling for a low credibility rating.

Private sector bonds are subject to regular tax treatment
In terms of returns, an important factor you need to be aware of is that NCDs are fully taxable. While there is no TDS involved, you are taxed according to the income tax slab you fall under. To understand this better, assume that the bond promises yields at a 10% rate and you come under the30% bracket, your post tax yield is only 7%. This raises the question of whether or not you should even consider the seemingly generous returns in light of the risks involved. The complications of assessing risks is further compounded when NBFCs with AAA credit ratings delay on payments.

Other instruments better match your expectations from the debt portion of your portfolio
As a retail investor, gauging the stability of an instrument can be tricky, and time consuming too. In such a case, it can make much more sense to allocate the debt portion of your investment mix to other, safer instruments. While saving schemes like NSC and PPF have ceased to provide adequate benefits, especially post the 10bps cut, the tried-and-tested fixed deposit is still a worthy alternative. In fact, FDs provide superior liquidity too, whereas exiting a corporate bond when you desire may not always be possible.

In a nutshell, given the current economic climate and the fact that it is extremely difficult for a retail investor to judge the safety of an NCD, it's probably best to steer clear of them and consider a fixed-income instrument, like a tried-and-tested fixed deposit, instead.

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