Faced with low rates on bank fixed deposits (7-7.5%) and a volatile bond market, retail investors are looking for an alternative investment that will deliver better risk-adjusted returns with lower volatility. In this backdrop, non-convertible debentures (NCDs) offering 9.1-9.75% returns appear attractive. Should retail investors buy NCDs based on the interest offered, rating or are there other factors?
Portfolio diversification
While Dewan Housing Finance Corporation's NCD issue opened on May 22, J M Financial Credit Solutions’ NCD is opening on May 28. DHFL is offering 8.9-to 9.1% and JM Financial Credit Solutions is offering 9.25-9.75% across various maturities.
From purely an investor point of view, NCDs definitely have a role in the portfolio. "NCDs provides a stable and regular source of income over a period of time. As part of the fixed income allocation of an investor’s portfolio, NCDs enable diversification of investments from the duration and credit risk perspective," said Harshil Mehta, joint MD, and CEO, DHFL.
In a volatile market, NCDs provide stability to a portfolio and reduce the overall volatility considerably, added Mehta.
Consider an investor who wants to invest in a three-year AAA private bank FD and a three- year AAA secured NCD. "The investor would be offered 8-9% interest rates on NCD and 6-7% on the FD, with a similar lock-in period. The latter is subject to a TDS deduction whereas, there is no such deduction on Secured NCDs, thus giving the NCD investor more cash in hand on maturity from which he can then pay taxes," said Tarun Vohra, founder, and CEO, Integra Profit.
Ratings divide
The bigger question is whether NCDs, which generally offer higher rates than bank FDs, are equally safe. "Investors with a moderate or high-risk appetite can consider NCDs for their fixed income portfolio. However, the decision making should not be based on coupon rates only," said Manish Kothari, director & head of mutual funds, Paisabazaar.com.
The ratings make difference. For instance, JM Financial Credit Solutions' NCDs are rated AA/Stable by ICRA and IND AA/Stable by India Ratings. DHFL's NCDs have received triple AAA rating from CARE and BWR AAA from Brickwork Ratings.
"Generally, issuers with lower credit ratings have a higher risk of default and hence, they pay higher coupon rates to compensate for the higher risk," Kothari pointed out.
Do these ratings really matter? According to Milin Shah, head product development & planning, HappynessFactory.in, ratings indicate the quality of the instruments from a very broad perspective.
"However, beyond a point, ratings do not reflect the real risk of the debt investments. There were several instances globally when there was a very low correlation between the ratings assigned and occurrence of defaults. Besides, ratings do not change frequently in tandem with the change of risk in the business cycle or economy,” he said.
Expected returns should not be the only parameter for investment but it also important to understand the credit risk. Mostly in good economic situations, corporates do not default, but the situation may turn risky, if the economy sees a downturn. “The best way to manage such credit risk is to buy a pool of such papers, that is, through debt mutual funds that invest in corporate bonds,’’ Milin Shah added.
Checklist
Although NCDs are traded in stock exchanges, they have very low liquidity. An unforeseen financial exigency may force you to sell your NCDs at a discount. Hence, factor in your liquidity requirements before investing in an NCD issue and invest in it only if you can stay invested till maturity, added Kothari.
A recent report by CRISIL states that no instrument with AAA rating has ever defaulted, but while defaults have increased in case of lower rated bonds. Also, companies with low ratings offer very high returns, which attract investors.
There are issues that offer over 10% annual returns that are rated AA+, but lower ratings certainly come with more risk than AAA rated issues, said Sachin Shah, fund manager, Emkay Investment Managers.
"In such a case investors need to look at the background of the company and whether it has a track record of repayment. Only if investors understand the business and have faith in the management should they go for such issues," he advised.
As a precaution, always check certain the company’s financial health and end use of funds before investing.
WATCH OUT FOR CREDIT RISK
- Opt for higher rated NCDs
- Lower ratings could mean higher default risk
- Look at issuers’ financial health
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