3 things to look at before you invest in NCDs

Of late, several NCD (non-convertible debenture) issues have been coming in the market. The current low interest rates on bank fixed deposits add to the appeal of these NCDs (or bonds) - both in the new issues as well as those trading in the secondary market.

If you are looking to invest in NCDs to better your debt returns, here are a few points to note.

Return metrics

The fixed coupon or interest rate, calculated on the face value of the bond is what an investor receives periodically (say, quarterly, half-yearly or annually) in the form of interest income. This is the ‘return’ most investors usually focus on. If you invest in an NCD in the primary issue and stay invested until maturity, then the periodic coupon or interest indicates your investment return.

Alternatively, if you buy an NCD in the secondary market and stay invested until maturity, then you must focus on the YTM (yield to maturity) rather than the coupon rate as the correct indicator of your return. The YTM takes into account not just the periodic coupons but also the price at which the bond is bought and redeemed to arrive at the total return. Let’s take an example. Secondary market data from HDFC Securities shows that AAA-rated Tata Capital Financial Services bonds (series - 890TCFSL23 - Individual) priced at ₹1,123 per bond, with a residual maturity of 2.07 years offer a coupon of 8.90 per cent and YTM of 6.79 per cent. A YTM lower than the coupon implies that a bond is trading at a premium. That is, the current market price of the bond is greater than its face value. The latter is what will be paid to you on maturity. In the prevailing low interest rate environment, an 8.9 per cent coupon bond commanding premium pricing is hardly surprising.

Then, there are NCDs that come with a call or put option. Callable bonds give the issuer the right to call back the bond before its maturity by paying back the principal. Putable bonds give the investor an option to exit before maturity and receive the principal. In case of NCDs with a call option, the appropriate return metric to look at is YTC (yield to call) and not YTM. The YTC is the return that an investor gets if the bond is held until the call date. Only very few retail NCDs come with such an option.

Exit or not

While NCDs get listed on the stock exchanges and provide the possibility of an exit option, not many can be bought and sold as easily as shares. This is due to the lack of adequate trading volumes for many NCDs in the retail segment. In such a case, one must be prepared to stay invested until maturity.

Once an NCD lists on the exchanges, it may trade at a price different from its issue price. Over time, the value of the bond will fluctuate in response to factors such as interest rate changes and ratings upgrades or downgrades. So, if you sell a bond before maturity, your final investment return will be impacted by the difference between the selling price versus the purchase price of the bond. This could result in a capital gain or loss for you. Today, with interest rates expected to rise, albeit not immediately, the existing lower-coupon bonds carry the risk of depreciating in value over time resulting in a possible capital loss when sold.

Taxation

The coupon or interest received from NCDs is taxed at your income tax slab rate. Short-term capital gains are taxed at your slab rate. Long-term capital gains in case of listed and unlisted NCDs are taxed at 10 per cent and 20 per cent (both without indexation) respectively.  Capital gains on sale of NCDs that have been held for more than a year in case of listed NCDs and more than three years in case of unlisted ones are treated as long-term in nature.

NCDs in the retail segment quote at their dirty price. That is, the quoted market price is inclusive of the accrued interest on them.

According to Nimish Shah, CIO, Waterfield Advisors, when an NCD is sold, the differential between the sale price and the purchase price is segregated into two parts – capital gains and accrued interest – for taxation purposes. Let’s say, you buy a bond with a coupon of 8 per cent per annum (paid semi-annually) at a face value of ₹100 in January. Suppose this bond is trading at price of ₹110 on March 31. Since the first coupon payment is due in June, the accrued interest by March-end is ₹2. The difference between the sale and purchase price of the bond of ₹10 will be split into two parts – ₹2 accrued interest and ₹8 capital gains and taxed as such – when the bond is sold in March.

COMMENT NOW