Debt Funds vs NCDs

Debt Funds vs NCDs

20 Jun 2019

Buying a debt instrument is similar to giving a loan to the issuing organisation. A debt fund invests in fixed-interest generating securities like corporate bonds, government securities, treasury bills, commercial papers and other money market instruments. Meanwhile, the debentures which can't be converted into shares or equities are called Non-Convertible Debentures (or NCD’s). Here, the investor receives some fixed amount of interest, depending on the term of the debenture; let us understand both in greater detail below:-

Debt Fund - A debt fund is an investment pool, such as a mutual fund or an exchange-traded fund, in which core holdings are fixed income investments. A debt fund may invest in short-term or long-term bonds, securitized products, money market instruments or floating rate debt.

NCD’s - Investors in NCD’s want investment options that manage liquidity and risks while offering substantial returns. Debentures are long-term financial instruments issued by a company for a specified tenure with a promise to pay a fixed amount of interest to the investor.

People who traditionally put their money in fixed deposits are the ones who invest in non-convertible debentures (NCD) issues. Let us discuss whether it makes financial sense to invest in NCD’s.

Key features of NCD’s -

  • There is always an aggressive buying of NCDs by retail investors.
  • The interest rates would be steady in the near future due to a slower credit offtake and liquidity in the banking system.
  • There will be continuation of investments in debt funds unless investors understand the nuances of businesses offering NCD’s.
  • Both products (NCD’s and Fixed Deposits) offer fixed rates and thus people think that they are similar.
  • Investors prefer NCD’s over company deposits because the money in the latter needs to be locked in for the tenure of the deposit.
  • The secondary markets for debt are not well developed.
  • The buyer’s bids in the debt market are much lower and if the seller needs the money urgently, then he would need to exit at a loss.
  • As per the experts, NCD’s should be avoided by retirees or those nearing retirement.

Are NCDs riskier than fixed deposits? - ‘Yes’, because they carry higher interest rates in comparison to fixed deposits. Before investing in NCDs, check out the company’s financial health and credit profile; in case of poor credentials, there is a possibility of a default which is rare in the case of fixed deposits. Avoid investing outside well established names as lesser known names may give higher interest rates but carry higher risk than the more established and popular names. It is advisable not to buy any NCD with a credit rating lower than AA. Short term debt funds are better than NCDs for those who are in the highest tax brackets and the reasons are as follows:

  • Debt funds are more tax efficient.
  • According to the income tax slabs, all the gains are added to the income and taxed in Non-Convertible Debentures (NCD).
  • Debt funds are safer than investing in a single issuer because they spread the risk across companies by investing in a portfolio of papers.
  • Professionals invest in the companies only after evaluating them.

Interest rates of NCD’s are attractive for those in the 10 per cent and 20 per cent tax brackets, but they should first exhaust their Public Provident Fund (PPF) limit or look for other safer investment avenues before investing in NCD’s. One has to fully understand the risks involved in NCD’s. If a small investor doesn’t understand such risks, a bank fixed deposit will be a better option for him / her. For example, a triple -AAA rating means that the issue is one notch below instruments that have a sovereign guarantee. The lower ratings mean that they carry higher risks. Investors need to look at the background of the company in case of poor ratings and also check if it has a track record of repayment. Only if investors understand the business and have faith in the management should they go for NCD issues.

So, take your pick, and choose wisely!

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