If you have been regular to personal finance blogs or financial newspapers you would often hear about NCDs or Non-convertible Debentures. This post explains the following concepts about NCDs:
- What is NCD?
- Secured Vs Unsecured NCD?
- Put Vs Call Option in NCD?
- How to Apply for NCDs?
- How to Hold NCDs – Physical Form or Demat?
- Taxation and TDS on NCD?
What is NCD?
Non-convertible Debentures (NCDs) are similar to Fixed Deposits (FD) but they are issued by companies to raise funds from investors for their business. They are called Non-convertible as they cannot be converted to shares of the issuing company on a future time as in case of Convertible Debentures. They are also popularly known as Bonds or Debentures.
Similar to FDs, the companies pay a fixed interest for the entire tenure of investment. This interest rate is known as coupon rate for NCDs.
Types of NCDs:
Based on whether the fund raised by the company is backed by asset or not, it’s classified as Secured vs. Unsecured NCD.
1. Secured NCDs:
- As the name suggests, in case of Secured NCDs the funds raised by company is backed by its assets.
- In case of default by the company in payment of either principal or interest due, the asset can be liquidated and investors can recover their money.
- Hence it has Lower Risk but Pays Lower Interest Rate than unsecured NCDs
2. Unsecured NCDs:
- As the name Unsecured suggests the funds raised by company are not backed by any security.
- Hence it’s more riskier than Secured NCDs but pays higher interest rate
Based on payment frequency of interest on NCD, it can be classified as Cumulative Payout or Regular Payout.
1. Cumulative Payout:
- In case of Cumulative Payout the principal and all interest accrued is paid on maturity
- Suits investors who want lump sum money at the time of maturity
- More risky as you need to wait till maturity for entire payment
2. Regular Payout:
- For Regular Payout options the payment of interest is at pre-determined regular intervals like monthly, quarterly or annually
- Suits investors who need regular income
- Less risky as the payment is at regular intervals
Tenure of NCD
NCDs can be offered with maturity period ranging from 1 Year to 20 Years. But there could be two options here:
1. NCD with Call Option:
- A NCD is said to have call option if the issuer has the option to redeem the NCD anytime before maturity
- It’s preferred by issuers and hence offers higher interest rate
2. NCD with Put Option:
- Just opposite to Call Option, in Put the investor has option to redeem his NCD before maturity
- It’s preferred by investors as they can redeem their NCD anytime leading to lower interest rates
How to Apply for NCDs?
Companies regularly come out with NCD offers throughout the year. These NCDs are offered by financial institutions, banks, and brokers etc to retail investors.
In case you have Demat Account, it’s easiest to apply through that. There is no paper work and everything can be done online.
In case your Demat account is not offering the NCD, you can apply through filling up physical forms available with sellers of the NCDs. There you can mention your Demat Account Number and the NCDs would be allotted to your Demat Account.
You can also buy and hold the NCDs in physical form.
How to Hold NCDs – Physical Form or Demat?
As stated above you can be allotted NCD both in Physical Form and Demat Form. If you have Demat account it’s always advisable to get NCD in Demat form. Demat form of Holding have the following advantages over Physical Certificates:
- Many companies do not offer NCD in Physical forms. Even if they do not all investment options would be available for Physical allotment. For e.g. in case of recent Muthoot Finance NCD option 10 was not available for Physical Holding.
- If needed, the NCD can be bought/sold on stock exchange if held in Demat form
- There is no TDS deduction for NCD held in Demat form, while in case of NCD held in Physical Form, TDS would be deducted
How to Buy/Sell NCDs?
Most of the NCDs are listed on at least one Stock exchange (NSE/BSE). But unfortunately for most of NCDs the liquidity is low on Exchange and hence it’s difficult to buy/sell at fair price. If you need to exit urgently, be prepared to sell at a discount. That’s why it’s recommended to invest in NCDs with view to hold it till maturity.
Income Tax on NCDs:
For Tax Purpose NCDs are treated as Debt Investment (similar to FD). The interest earned is added to your income as “income from other sources” and taxed accordingly.
Capital Gains Tax on NCD:
In case the NCD is sold before maturity on stock exchanges, it would lead to Capital Gains and taxed according to the holding period.
- If the NCD was sold within 12 months of allotment, it leads to Short Term Capital Gains and
- if the selling period is more than 12 months its Long Term Capital Gains
- Short Term Capital Gains would be added to income and taxed accordingly
- Long term capital Gains would be taxed at the flat rate of 10% (u/s 112 of IT Act)
TDS on NCD:
There is no TDS (Tax deduction at Source) deduction for NCD held in Demat form, while in case of NCD held in Physical Form, TDS would be deducted if the annual interest payout is more than Rs 5,000.
NCDs are good investments and should have a place in your Debt Portfolio. If carefully chosen they offer higher returns than Bank Fixed Deposits.
However there are few things you should keep in mind:
- Always invest in High Credit Rated NCDs and from well known companies. Make it a rule not to invest below AA- rated issues. (Read more about Credit Rating of NCDs)
- Never invest in companies/sectors that are going through bad phases or have shoddy business practices like Real Estate companies.
- The due diligence process is similar to equity investment. Do not buy NCDs of the company if would be not comfortable buying their shares.
- The price of NCD increases with fall in interest rates and vice-versa.
- You should always diversify i.e. have NCDs of different companies rather than putting all money in one company
- Its good idea to remain invested till maturity because liquidity on exchanges is low and hence selling mid way would get lower than market value
Please share your thoughts in case I missed something or you have any questions!