Interest rates have been on the rise over the past 18 months. As a result, many fixed-income instruments have become attractive, even market-linked ones such as non-convertible debentures (NCDs). Many firms, mostly NBFCs (non-banking finance companies), have been coming out with NCD offers over the past year or so. Some of these NCDs may be too risky despite the high returns that they offer. It becomes important for retail investors to understand the key terms associated with NCDs such as coupons, yields, face value, tenor and the like.

There are other debt instruments such as tax-free bonds and many NCDs that are traded in the BSE and NSE. Investors must also be aware of these to make informed decisions. Here’s more on what retail investors must know before venturing to invest in NCDs. Of course, it goes without saying that analysing the financials and prospects of a firm – to gauge the ability to repay interest and principal amounts – is equally important.

Understanding the terms

There are many bond-market terms used while dealing with NCDs. Some clarity on these terms may be useful.

Coupon: These debentures come with a coupon or an interest rate. This is just like interest rate on fixed deposits. Since NCDs are market-linked products, you must look for options that offer higher interest than deposits. However, you must understand that not too much risk must be taken in pursuit of higher interest. So, about 100-150 basis points more than the best private and public sector banks’ deposits for similar periods would be a good reference point. Interest rates that are equal to or a bit more than what quality small finance banks offer and top NBFC deposits give are other thresholds. Anything more may be too risky.

Face value: These debentures or tax-free bonds are assigned a face value. Coupons are paid as a percentage of face value of NCDs. The face value is usually ₹1,000 per bond.

Interest frequency: The frequency is based on the tenor and type of payout that you choose at the time of application. Annual and monthly payout options are common. Cumulative NCDs are also available. Depending on your cash flow requirements, you can choose the frequency that suits you. Cumulative option can be avoided by conservative investors and regular interest payouts can be taken.

Tenor: NCDs come in various timeframes ranging from two years to as high as 10 years. Usually, coupons are set higher for longer tenors. For retail investors sticking to two or three-year tenors are advisable. Five-year tenors are fine if the coupons are really attractive and the risks are low. Avoid locking into any more than 5-year tenors.

Credit rating: This is an important criterion while choosing NCDs. AAA and AA rated issues can usually be considered. For A-rated securities, it is better if it is issued by a reputed corporate or is backed by a conglomerate. You must avoid any lower rated securities such as BBB and the like even if the coupons on offer are very high, even in double digits.

Making sense of yields and returns

One of the key aspects of market-linked instruments in the bonds space is to understand the concept of yields. For investors looking to deploy money in NCDs in the primary issue, usually, the coupon and yield are almost the same, give or take a few basis points.

Yield is what we get as return for cash outflow (principal amount) and inflows (interest and principal repayment) over the tenor of the bond. So, the key is holding a bond till it matures and not selling it in between if you want the yield (yield to maturity) for which you bought the NCD.

When NCDs or bonds start trading on the BSE or the NSE, their prices change periodically. Bond prices and yields move in opposite directions.

In Indian debt markets, in general, the volumes of bonds traded are pretty low. There are times when trades do not happen in some counters for days together. A select few categories such as G-Secs and a few tax-free bonds, and highly rated corporates have reasonable volumes, though.

When the yields are much higher (more than 100 basis points) than the original coupons on offer on an NCD or bond issue, it may indicate some rating downgrade, raising interest rates leading to unfavourable scenarios for the firm.

You must be on the alert to avoid risky bets where yields have risen suddenly due to adverse circumstances and not try your luck chasing higher returns as you may end up losing capital or interest payouts.

Of course, based on just a rising interest rate scenario without any change in the fundamentals of a firm, if its NCDs trade at a higher yield than the coupon, it may present an attractive entry point for better returns.

Another key point of reference to gauge the yields in the secondary or even primary market is to check the yields of what similar rated bonds trade at in the secondary market. Many brokerages and financial entities bring out the category average of yields for various corporate bonds rated AAA, AA, A and so on.

If the bond you like to buy offers the same or a bit more (say 50 basis points) in terms of coupon rates or yields, you can consider such instruments. A much larger spread of, say 100 basis points, may not too risky, while a much smaller spread can render it unattractive.

For retail investors, investing in NCDs must in general not be more than 5-10 per cent of their debt portfolio and they must take the above factors into consideration before taking the plunge.