May 012012
 

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Earlier we explained “What are Non Convertible Debentures (NCD)?”. Understanding the basics of NCD is important for investors who wants to invest into it. As we discussed, NCDs are like bank fixed deposits where investors invest there money and get a fixed rate of interest on their investment. The high rate of interest on these fixed deposit instrument over equity market returns in recent years has taken NCDs more into lime light. But while investing under NCDs investor should not only look for ‘Yield to maturity (YTM)’ or coupon rate, it is equally important for an investor to look for the other factors that can impact your returns on investment.

Yield To Maturity (YTM) :- While investing under Non Convertible Debentures (NCD), it is important for investors to look beyond yield to maturity. Which means investing by looking only at yield of the investment product can take away the overall benefit of your investment.

What Is Yield To Maturity (YTM) ? :- The annual return on fixed income investment expressed in percentage.

You must be wondering if YTM is not the only parameter to choose NCD then what else one should consider while making investment under NCD. The answer to this question is very simple and obvious i.e tax implication on your investment product. Here when we talk about investing under NCD, the important factor that can directly impact your return on investment is Tax.

Here For Example: Two companies A and B offers NCD

Company Face Value Quote Coupon Rate YTM
A Rs 1000 Rs 925 11.90% 14.73%
B Rs 1000 Rs 1028 12% 15.71%

As an investor, if you have to choose between one of the above two companies for investment under NCD most of you find company B as a better alternative as it is offering better YTM over company A. But when we look at the other side of the coin i.e tax implication on NCD then we find that in case of company B investor will get the face value of Rs 1000 + interest + capital gain or loss on maturity. But purchase of NCD at Rs 1028 (face value Rs 1000) will make you take home a capital loss of Rs 28. As you will get the difference amount i.e Rs 28 in the form of interest on maturity which will taxable in your hands.

Nonconvertiblebonds

Non Convertible Debentures (NCD) : Features

  • Listed Securities :- NCDs are listed on stock exchanges.
  • Demat Account :- Investor can purchase or sale NCDs using demat account.
  • Liquidity :- Can be traded in secondary market hence offers liquidity to investor.
  • Tenure :- The tenure of NCDs are usually between 2  to 20 years.
  • Credit Rating :-  NCDs are rated by rating agencies such as CRISIL.
  • TDS :- There is no TDS deduction on interest earned on NCDs.
  • Interest :- NCDs are generally offered in four options: monthly, quarterly, annual and cumulative interest

Non Convertible Debentures (NCD) :- Risk Associated

Investment which offers higher returns comes with additional risk and same is applicable for NCDs too. In case of NCD’s, the rate of interest on NCDs are fixed which is paid to the investors on maturity.

  • If investor wait till maturity then there is no risk of capital loss. But if investor sells his NCD in the secondary market when the rate of interest is higher than that being offered by the debenture, the return on investment for the investor will be either less or even negative. As the buyer will purchase those NCDs at a rate which allows him to get the return equal to prevailing market rate. For Example : – If Mr.A sells his NCDs in the market:-
Face Value Quote Coupon Rate Return On Maturity
Purchase {Market Rate @12%} Rs 1000 Rs 1000 12% Rs 1120
Sell {Market Rate @14%} Rs 1000 Rs 982 12% Rs 1120 (Rs 982 + 14% * Rs 982)

Here, Mr A bought NCDs at the rate of Rs 1000 @12% and sells when rate of interest was 14%. So in this case he will suffer a capital loss of Rs 18 as buyer will pay Rs 982 for the NCDs of Rs 1000 to get return on maturity @14% (prevailing market rate) instead of 12%.

On the other hand if the buyer sell the NCD when the rate of interest was 10% then we will get the capital gain on his sale. As he will sell the NCDs at a rate higher than face value so that buyer will get the rate of return @ 10% (prevailing market rate) instead of 12%.

  • As NCDs are issued by companies, there is the risk of default by the company.
  • It is a less traded security, which means finding buyer for your instrument not very easy.

Non Convertible Debentures (NCD) :- Tax Implications 

The rate of interest earned on NCD is taxable. As there is no tax deducted at source (TDS) deduction in NCDs, on sale or maturity the amount of return (if any) gets clubbed in the income of the investor as “income from other sources” and taxed at the applicable income tax rate.

While short term capital gains on sale of NCDs would be taxed at normal rates, long term capital gains on sale of NCD (a listed security) are taxed at concessional rates u/s 112 of IT Act.
In general, the tax rate on long term capital gains on listed securities is 10% without indexation and 20% with indexation whichever is lower. However, in case of debentures this benefit is not available so long term capital gains from NCDs are taxable at a rate of 10.30% (including education cess of 3%) without indexation.

Non Convertible Debentures (NCD) :- Benefits

  • Some NCDs offers put and call options :- The put option offers investor to sell back the security to the company after a specified period of time. For Example :- Company A offered call & put option after completion of 2 years from the date allotment. If interest rates offered to the investor were higher and company decided to revise interest rates after 2 years, if not ok with revised interest rate then investors can exercise put option and exit from the NCDs with principal and accumulated interest (if any) as on the date.
  • Liquidity :- There is no restriction on sale of NCDs which allows investor to sell his investment anytime in the stock market.
  • Rate Of Return :- NCDs offers higher interest rate as compare to other fixed deposit instruments like bank fixed deposits.
  • Security :- Secured NCDs are backed with some company asset which means in case of default the asset of the company will be sold to pay off your money.

Whether Investors Should Invest Under Non Convertible Debentures (NCD) Or Not?

Investing completely into NCDs to earn fixed income on investment is not a good idea. One can invest in non convertible debentures (NCD) to diversify portfolio. Investors should always check the credit rating of the company before investing to save from default. NCD are for long term investment (5 to 15 years) so to take full benefit, investor should always keep in mind the tenure of the investment before investing.

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