BAJAJ BROKING
August 30, 2024
7 mins read
The financial market has many options for investments, each suitable for different levels of risk and financial goals. For example, Non Convertible Debentures (NCDs) from Non Banking Financial Companies (NBFCs) could be a good choice for traders who seek high returns while diversifying their portfolio of assets. However, since this could be a perplexing topic for new entrants into the stock market, the aim of this article is to define non-convertible debentures, and their benefits along with potential risks. This detailed guide will give you all information needed to make smart choices when the time arrives to make your NBFC NCD investment.
After you open a demat account and begin trading on the stock market, you might wonder about the meaning of non convertible debentures given the popularity of the term in the financial world. Non Convertible Debentures (NCDs) are debt instruments that are similar to fixed deposits given by banks. However, in this case, it is not the banks but NBFCs (Non-Banking Financial Companies) that issue NCDs to raise capital for their business needs. NBFC shares represent financial companies that offer banking services like giving loans and making investments, but they are different from banks as they do not offer checking account services or issue demand deposits.
When you make an NCD investment with an NBFC, it means you are lending your cash to the NBFC for a set time at a fixed interest rate. The NBFC assures to give back the principal amount you put in, plus any interest it will earn when it matures. This should answer the common question, “What is NCD?”.
NBFC non convertible debentures offer some key features that differentiate them from other investment options:
Fixed Interest Rates
Unlike investments like stocks where returns fluctuate, NCD investment provides fixed interest rates throughout the investment tenure. This predictability allows you to plan your finances more effectively and offers a steady stream of income.
Variety of Terms
NCD investments come in various maturities, ranging from a few months to several years. This flexibility allows you to choose a term that aligns with your financial goals. For instance, if you have a short-term goal like funding a down payment, you can opt for an NCD with a shorter maturity. For long-term wealth creation, longer-term NCDs might be suitable.
Liquidity Options
While answering the question “What is NCD and what makes it different from FDs?”, it is important to note that while some non convertible debentures are similar to FDs and cannot be traded before maturity, others are listed on stock exchanges. These listed NCDs provide liquidity if you need to sell your investment before maturity. However, it's important to note that selling before maturity might come with penalties and could potentially lead to lower returns than holding the NCD till maturity.
Potentially Higher Returns
Compared to traditional fixed deposits (FDs) offered by banks, NBFC NCDs can offer potentially higher interest rates. This can be an attractive proposition for investors seeking to maximize their returns through NBFC shares.
NBFC NCDs can be a valuable addition to your investment portfolio, but there are also potential drawbacks to consider. Let's analyze both sides of the coin to help you make an informed decision.
Advantages of Investing in NBFC NCDs:
As mentioned earlier during our discussion about the meaning of non-convertible debentures, they can offer attractive interest rates compared to traditional debt instruments like FDs. This can be particularly beneficial in a scenario where interest rates are on the rise.
The interest earned on non-convertible debentures is taxable as per your income tax slab, similar to bank FDs. However, depending on the tax bracket, there may be some benefits in certain cases.
Incorporating NBFC NCD investment into your portfolio can help spread your risk across different asset classes. This diversification strategy can improve your portfolio's overall returns and reduce volatility.
Disadvantages of Investing in NBFC NCDs
Unlike banks, which are tightly regulated by the RBI (Reserve Bank of India), NBFCs might not be as creditworthy. There is even a chance that the NBFC might default on its repayment obligations, meaning you could lose some or all of your invested capital. Therefore, it is of the utmost importance to take stock of the NBFC share fundamentals along with its creditworthiness before making your NCD investment.
Not all non convertible debentures are listed on stock exchanges. If your NCD investment isn't listed, selling the NCD before maturity could be difficult. This lack of liquidity can be a drawback if you need access to your money before the investment term ends.
Since NCDs offer (more or less) fixed interest rates, they are susceptible to interest rate fluctuations. If market interest rates rise after you have invested in an NCD, you might be locked into a lower rate of return compared to other investment options available at that time.
The following are a few points to guide you through the NCD investment evaluation process:
Credit Rating of the NBFC
When speaking about the meaning of non convertible debentures, it is necessary to note that they are not backed by any bank collateral. Therefore, the credit rating of the NBFC issuing the NCD is a crucial factor to consider. Credit rating agencies like CRISIL and ICRA assess the financial health and creditworthiness of NBFCs. Higher credit ratings (typically, an NCD with a AAA rating is the safest to invest in) generally indicate a lower risk of default. Opt for NCDs issued by NBFC shares with strong credit ratings to minimize your credit risk.
Interest Rate Offered
Compare the interest rate offered on the non convertible debenture with other investment options like FDs or bonds. While NBFC NCDs can offer potentially higher returns, don't chase excessively high rates. Unusually high rates might be a red flag and could indicate a riskier NBFC.
Listing and Liquidity
Consider if the NCD is listed on a stock exchange and how easily you can sell it before maturity if needed. Listed NCDs provide more liquidity compared to unlisted ones.
Read the NCD Offer Document
Carefully read the non convertible debenture offer document issued by the NBFC. This document contains vital information about your NCD investment, including the interest rate, fees, maturity date, and any potential risks involved. Understanding these details is crucial before making your NCD investment decision.
While NBFC NCDs can be a valuable investment tool, there are inherent risks involved:
Credit Risk
Credit risk is a primary concern with NBFC NCD investment. There's a possibility that the NBFC might default on its repayment obligations, leading to the loss of your principal investment.
Interest Rate Risk
Since non convertible debentures offer fixed interest rates, you are susceptible to interest rate fluctuations. If market interest rates rise after your investment, you'll be locked into a lower return compared to newer investments offering higher rates.
Call Option Risk
Some NCDs come with a call option clause that allows the NBFC to redeem the NCD before maturity under certain circumstances. This could disrupt your investment plans if you were expecting the income stream from the NCD until maturity.
The following is a step-by-step guide to help you get started with NBFC NCD investment:
Open a Demat Account
To invest in listed NBFC NCDs, you will need to open a demat account. This acts like a digital storage facility for your securities similar to how a bank holds your deposits. Many brokerage firms offer demat accounts along with trading platforms. If you already have a trading account with a broker, you can inquire about opening a demat account if you don't have one already.
Choose an NBFC and Invest
You must research different NBFC shares and their NCD investment options. Compare factors like credit ratings, interest rates, listing status, and maturity terms. You should choose an NCD that aligns with your investment goals and risk tolerance. Once you've chosen an NCD, you can invest through your broker's online platform.
The flexibility in the terms of NBFC non convertible debentures, their tax benefits, and the ability to diversify your portfolio are all attractive features. However, careful consideration is crucial before investing. This is because unlike banks, NBFCs are not as tightly regulated, and credit risk is a significant concern. Try to understand the NBFC's creditworthiness and ensure the chosen NCD sits right with your risk appetite while dealing in the financial markets.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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NBFC NCDs (Non Convertible Debentures) are debt instruments issued by NBFCs (Non Banking Financial Companies) to raise capital. You lend money to the NBFC for a fixed term at a predetermined interest rate, and they promise to repay you the principal amount upon maturity.
There are two main types of NCDs: secured and unsecured. Secured NCD investments are backed by the assets of the NBFC issuing the NCD, whereas unsecured NCDs do not possess any such collateral backing.
Benefits include potentially higher returns than FDs, tax benefits and portfolio diversification.
NBFCs may carry more credit risk than banks (potential default), interest rate risk (locked-in rate), and liquidity risk (difficulty selling unlisted NCDs before maturity).
NBFC NCDs tend to have higher returns than FDs but less than equity stocks (which also carry higher risk).
Consider the NBFC's credit rating, offered interest rate, liquidity, investment term, and carefully read the NCD offer document.
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