In the last 20 years since 1998, the RBI guidelines for NBFCs on NCDs and raising other forms of money have been substantially tightened. When interest rates start going down, many savvy investors choose to lock in their funds in the NCDs issued by NBFCs as they can lock in funds for a longer period of time at lucrative rates of interest. Let us understand why it makes sense investing in NCDs, the pros and cons of NCDs and also the advantages and disadvantages of NBFC NCDs.
NCDs or Non-Convertible Debentures are a popular method of raising funds for the NBFCs. If you look at the major borrowers in the NCD market, the majority of them are from the NBFC segment. Indiabulls Housing Finance, Muthoot Finance, Shakthi Finance, M&M Financial Services, Edelweiss Housing Finance, Dewan Housing Finance and SREI Infrastructure Finance are some of the popular names raising funds through the NBFC route.
What are the advantages of NBFC NCDs?
There are 3 major advantages that investors see in the NCDs issued by the NBFCs..
NCDs issued by NBFCs normally pay an interest rate of 150-175 basis points higher than what banks pay on their FDs. Since most of the NBFCs issuing these NCDs are reputed and well capitalized, investors do not see too much of a risk investing in them. Also, the fact that they are closely regulated by RBI is a positive feature of these NCDs. At a time when interest rates have been falling for the last 3 years in India, the NCDs offer a good instrument to lock in your returns for a longer period of time.
There is another advantage in these NBFCs apart from locking in at higher rates. If the rates start falling by another 25 to 50 basis points from current levels, then the investor also enjoys capital appreciation on these NCDs, which is evident in their market price.
Debentures typically have a first charge or a second charge on the assets of the issuer. Hence, they are secured and relatively safer compared to other unsecured forms of investment. This gives an added advantage apart from the higher rates of return and the prospects of capital appreciation.
Some of the risks of NBFC NCDs..
Investors also need to be cautious about the risks entailed in these NCDs before committing funds to them.
NBFCs are a heterogeneous class of assets. There are high quality NBFCs and there is also low-quality NBFCs. Investors need to use their discretion and invest in NBFC NCDs only after looking at the credit rating of this NCDs Credit rating is an expert opinion on the repayment capacity of the issuer and it is advised to stock to high rated NBFCs only.
NBFCs as a sector are quite vulnerable to regulation. Indian NBFCs learnt this lesson the hard way in 1998. When the RBI imposed heavy regulations on NBFCs in terms of capital adequacy requirements and asset classification, most of the 40,000 NBFCs operating at that point of time became bankrupt. The sector is still vulnerable to these kinds of macro and regulatory risks.
Tax-wise, these NBFC NCDs are not very efficient. For example, even though these NBFC NCDs pay around 9%-10% coupon rate, the actual returns are less than 7% on a post-tax basis. That is not a very attractive return when you compare to debt funds which also give you the added advantage of tax efficiency.
In conclusion, NBFC NCDs are suited to investors who have the higher risk appetite and willing to lock in their funds at a higher rate of return. For a lot of institutional investors this still makes a lot of sense but for individuals there may be a lot many attractive and lucrative investment opportunities in the market!