A company may need money for a variety of purposes. It may want to expand its business, build a new plant, buy machinery, buy new land to build a factory, embark on a new project, or even purchase another company.
The company can issue shares, or take a loan from a bank or financial institution, or borrow from abroad. It can also issue debt instruments such as debentures.
When you invest in a debenture, you lend money to the company that issues it (issuer). In exchange, the company promises to return your money (principal) on a predetermined date (maturity date), and till it does so, it will pay you a specified rate of interest (coupon rate).
Debentures are a financial instrument used by companies to raise long-term capital. They are debt instruments with a fixed tenure.
Debentures can be convertible or non-convertible.
Depending on the convertibility, debentures may be classified as Fully Convertible Debentures (FCD), Partly Convertible Debentures (PCD) and Non Convertible Debentures (NCD).
Convertible debentures are hybrids – part bond, part stock. They are attractive because they promise the security of a bond coupled with the option to convert to equity should the stock price rise.
They could be fully convertible (the entire value of debentures can be converted into equity shares of the company) or partly convertible (only a part of the debentures will be eligible for conversion into equity shares).
NCDs have no such option and will always remain a debt instrument and never have any equity component. To compensate for this drawback of non-convertibility, lenders are usually given a higher rate of return compared to convertible debentures.
Debentures can be secured or unsecured.
A secured debenture is backed by specific company assets. In case the company fails to pay up, the investors can get their money back by getting the company to liquidate its assets.
An unsecured debenture is not backed by the company’s assets. It is issued solely on the credibility of the issuer. Since they are not secured by any charge on the assets of the company, they will be subordinate to the claims of all other creditors. To compensate for the higher risk, they generally offer a slightly higher rate of interest.
IndiGrid Trust
India Grid Trust, a power sector infrastructure investment trust (InvIT), will launch its ₹1,000 crore NCD. We explain what an InvIT is here.
The attraction lies in the fact that it is a AAA-rated issue and offers rates of interest that are attractive, compared to what is available in the market.
- 3-year: 6.75% p.a.
- 5-year: 7.6% p.a.
- 7-year: 7.9% p.a.
- 10-year: 8.21% p.a.
While the rates seem lucrative, think carefully if you want to lock your money in for such a long tenure. Also, interest earned is taxed at the income tax slab rate.
If you are looking for fixed returns and are in the lower tax slab, this could be an option. If you are in the highest tax slab and looking for a debt allocation, maybe a dynamic debt fund, a corporate bond fund or a short-term bond fund may be more suited. When it comes to a debt fund, the diversification is beneficial.
- Since the NCD issue process is similar to the IPO process, you will have to have a demat account with a brokerage house to buy an NCD. The issuing company begins the public issue of its NCD for a specified period. They are then listed on the stock exchange.
- NCDs are be traded in secondary market. However, the debt market is not the best for individual investors when it comes to liquidity. So don’t buy NCDs with the aim of trading. Buy and hold till maturity.
- NCDs are listed and traded. If the market interest rate is higher than the coupon rate of debentures, then the value of debentures fall. On the other hand, if the interest rate is lower than the coupon rate of debentures, than people will opt for debentures with higher interest rates, thereby, raising its value. However, liquidity is low. You might not be able to find a buyer for your NCDs if the trading volumes are insignificant. You can understand the interest rates in more detail here.
- Don’t go overboard and invest a huge chunk of your debt allocation here. There is a concentration risk since you are investing in one company/entity. Also, it makes no sense to lock in too much for a very long period of 8 to 10 years.
