Five things to check before you invest in NCDs

The weakness in the stock markets and the high returns offered by debt instruments are making investors rush to the safety of fixed income options. After fixed deposits and FMPs, non-convertible debentures (NCD) have caught the fancy of investors. Right now, the NCD issue of India Infoline Investment Services was open for investment, with the company offering 11.9% on the 5-year bonds. Three more issues are in the pipeline. However, before investing in these bonds, here are a few things you should check.

How safe is your capital?

You are investing in debt because you want safety, right? However, private issuers can default on the repayment of the principal. This is where the credit rating of bonds comes into focus. Credit rating is an independent assessment of the ability of the issuer to meet its financial commitments. It's important because it also determines the price that a bond will command in the secondary debt market. A high rated bond will fetch a higher price than a bond with a lower rating.

The rating assigned to a bond is not for perpetuity as it may change with the fundamentals of the issuing company. Any downgrading of rating will bring down the price of the bonds in the secondary market. So, you need to keep your eyes open for any change in the rating of the bonds that you hold. Any variation in rating is usually announced by the agency and reported in the media.

Is the issuer on a sound footing?

Unlike in the case of bank deposits, which are insured up to `1 lakh, investments in non-convertible debentures are not backed by any guarantee. However, as a lender to the company, an investor in NCDs has the first right over the company's assets if it faces liquidation. However, this information is useful only if the company has sufficient assets. So, before investing, take a look at the company's financials. Check whether it is sufficiently capitalised and if it has a healthy book value. "Stay away from companies that have a highly leveraged balance sheet," says Ritesh Jain, head of investments, Canara Robeco Mutual Fund. A little bit of spadework here can save you a lot of heartburn later.

How liquid is the investment?

The investor is not obligated to hold the debenture till maturity because it can be traded in the secondary debt market. That's the theory. The reality is that these instruments are not very liquid and have very few buyers. So, check the liquidity of similar instruments issued by the company before you are taken in by the sales pitch. You may find that some NCDs are not traded for days, which is not the state of liquidity you expect from a product sold on a national exchange.

Is there a put and call option?

Some NCDs come with riders called put and call options. The put option means that the investor has the right to sell the NCD back to the company after a specified period, while the call option gives the company the option to repay prematurely. While the put option favours the investor in a rising rate scenario, the call option acts as a cushion for the company if the rates fall and it wants to retire the high-yielding NCDs prematurely. Find out whether the put and call options suit your needs before you invest in the NCD. For instance, the five-year NCDs by Shriram Transport Finance have a put and a call option after 48 months, whereas the Indian Infoline Investment Services NCD does not have any put or call option.

What is your post-tax yield?

Lastly, consider the tax implications of the investment. The yields being advertised by the issuers obviously do not take into account the tax liability of the investor. Any income from the NCD is to be added to the total income for the year and taxed at the normal rate. In the 10% tax bracket (income of up to `5 lakh a year), the 11.5% yield drops to 10.35%. In the 20% tax bracket (income of up to `8 lakh a year), it falls to 9.2%. And in the highest 30% tax bracket, it is barely above 8%, which is no more than that offered by the PPF.