What is NCD? NCD means non-convertible debenture. It is a long term investment avenue in the debt/fixed income segment. “Non-convertible” means these securities can not be converted into equity shares or any other form of securities.
Imagine you are investing in a bank Fixed Deposit. Essentially, the bank is borrowing money from you and paying you x% interest. What does the bank do with that borrowed money? It lends to other borrowers like corporates, home buyers, small businesses and so on.
For simplicity, let us say the bank charges them (x+2)% or (x+3)% interest on the money lent. Effectively, the bank is earning that 2-3% additional interest by being a bridge between investors and borrowers.
What happens when that bridge is removed and you are allowed to lend to businesses directly? This is the exact concept behind NCDs.
However, this also means that risk involved is more now as the bank is not involved as an intermediary.
A typical NCD structure
It is a long term contract between an investor and a borrowing company. Usually tenure ranges from 2-10 years. Investors can select the tenure from the options provided as suitable for their needs.
Once purchased, investors either hold the NCD till maturity or sell them in the secondary market. There is no option to pre-close your NCD as in case of FD.
At the time of maturity, the investor gets the maturity amount as per the pre-defined terms. Besides, coupon interest is paid at different intervals: Monthly/ quarterly/ yearly/ cumulative and so on.
Types of Non Convertible Debentures
There are two types of NCD:
- Secured NCD: These types of NCDs are backed by the borrower’s assets. In case the borrower fails to make payment to investors as agreed, investors can liquidate the asset backing this NCD and recover their money. Hence, they are considered safer than unsecured NCDs.
- Unsecured NCD: As the name suggests, these come without any asset backing. Naturally, they are considered more risky than secured NCDs. Higher risk has to be compensated with higher returns, so they usually offer more returns than secured ones.
Credit rating mechanism for NCDs
Borrower companies have to prove their creditworthiness using credit rating from reputed firms like CRISIL, ICRA, CARE etc.
A good credit rating means the company is well positioned to pay back investors on time. It translates into more confidence for the investors.
Lower credit rating indicates a higher risk and so investors demand more interest as a compensation.
Companies/borrowers whose NCDs rank at the lowest bands usually have to shell out hefty interest to secure funds from investors. They are known as “Junk category” investments.
More on NCDs, in the second part. Read here.
Disclaimer: The above content is for informational & educational purposes only. Not advice. Please consult your financial advisor before investing.
