A debenture is a long-term debt instrument that is used to raise huge capital for the company and is not secured by physical assets or collateral. It is an agreement/contract between the debenture holder (lender) and issuing company (borrower), depicting the amount owed by the company towards the debenture holders, which it promises to repay back at a future date along with the interest. Debentures are issued or say backed only by the general credit ratings and reputation of the issuer.
Types of Debentures
Debentures are classified into two on the basis of Security-secured and unsecured. On the basis of Convertibility – there are convertible and nonconvertible debentures. On the basis of Negotiability – there are registered and bearer debentures. On the basis of Permanence – redeemable and irredeemable Debentures. On the basis of Priority, first mortgage debentures and second mortgage debentures.
Convertible debentures have a feature of convertibility into shares or equity after a certain point of time, at the discretion of the debenture holder. Non-convertible debentures can’t be converted into shares or equities and are used as tools to raise long-term funds by companies going through a public issue. As these bonds carry a drawback of non-convertibility, lenders are lured by giving a higher rate of interest compared to convertible debentures/fixed deposits, however, the interest rates depend upon the company issuing the NCD.
The market for NCDs is diverse, broad and can be held by individual investors, primary dealers, banking companies, other corporate companies registered or incorporated in India and unincorporated bodies, Foreign Institutional Investors (FIIs) and Non-Resident Indians (NRIs). Investors invest in secured NCDs to get multiple investment benefits.
Besides higher rate of interest, NCDs also offer various other benefits to the debenture holder such as tax exemptions at source, high liquidity through stock market listing and safety of capital and income. They are generally issued by companies which have a good credit rating and fulfill the specified norms laid down by RBI for the issue of NCDs. There is absolutely no doubt about the fact that there is risk of default here, however, the onus is upon the investor to make the right choice in terms of financially strong companies. In India, minimum maturity period of these bonds is 90 days.
What to check before investing In NCDs? (A quick checklist)
Check Company’s Background It is important to make sure to research the company’s history before you invest. You can always go back, skim at the records and check if the company is doing it for the first time or it has raised money in the past. If it does have a history of raising capital, has it successfully repaid its debts? If the company had met its obligations comfortably, it is a fairly good signal to go ahead. Else, you might need to consider other options or assess and evaluate if you can take that kind of risk.
Check Company’s Credit Rating Investors are attracted towards NCDs as they offer higher interest rates than that of an FD. However, that may not just be enough to make an investment decision. The credit risk suggests risk or simply put, the probability of an investor losing money. So, it is important that the issuing company is backed by good credit ratings. Credit rating calculates/depicts the firm’s potential to raise cash from its internal and external operations and its sustainability in extremes. This is however, not a sacrosanct parameter and is susceptible to the vagaries of the credit rating agency.
Level of Debt A check on the asset quality of the company can also be checked by doing some background check. For example, if the company allocates more than 50% of their total assets towards unsecured loans, then it is suggested not to invest. The 50% is not a hard-and-fast-rule and is more of a safe estimation only.
Coupon Rate It is the rate of interest offered by the issuing company on NCDs. Higher the risks, higher the rates. Interest payouts could be monthly, quarterly, half yearly or annually.
Capital Adequacy Ratio CAR is a gauge used to measure the company’s capital and see if the company has sufficient funds to repay at extremes. If a company has at least 15% CAR and has maintained the same historically, you can go ahead and invest in that firm.
Interest Coverage Ratio Another aspect to take into consideration is Interest Coverage Ratio or ICR, which ultimately determines if the firm can settle the interest on its loans even at the time of potential losses.
How to Buy NCDs/Bonds?
Companies, which are authorized to issue NCDs, will commence the public issue of NCDs for a specified period of time. After that the NCDs are enlisted on the stock exchange, it is available for investors who are interested in investing in the NCDs. The purchase can be made through registered brokers. As the public issuing of the NCDs is declared, investors can also invest in them by submitting a physical form, filling in the details as requested. PAN card details need to be provided to the issuer of NCD.
Online investment through your Demat Account is also an option. You can log into your trading account. The NCDs are booked in your Demat account. After the Public Issue of the NCDs, they are listed on NSE or BSE or at times on both. NRIs can also invest in select NCDs.