What are Non-convertible debentures (NCDs): Meaning, Types and How they work?

Last Updated: 17 Jan 2025

The Indian stock market is a complete solution for investing in a number of securities and making wealth by investing in the stock market over a period of time. In the stock market you can earn a return on your investment such as equity, And if you want to invest in low risky instruments then you can invest in debt instruments which offer a safer investment compared to equity or other volatile instruments.

To highlight a less riskier investment and earn constant gain you can invest in debentures.

What are debentures?

Debentures are unsecured bonds. Unsecured bonds are those that have no specific collateral or security tied to them. In case the issuer company fails in paying the interest or principal to bond holders, when they become due, the bond holders will have to make claims against the general assets of the company, in order to get their money back. There will be no specific assets that will be automatically put to sale to pay back the bond holders, the amount that is still owed to them. Debentures are usually issued for a long term, say for a period of more than 5 years. Debentures can be issued by companies as well as governments and their agencies.

Besides debentures or unsecured bonds, there are secured bonds too. Secured bonds are those that have a collateral or security tied to them. So if the company whose debentures you have bought defaults on the interest or principal that is due to you, the secured asset or collateral will be sold to pay that interest or principal. The security is usually some asset of the issuer company.

What are Non-convertible debentures (NCDs)?

Non-convertible debentures (NCDs) are those that cannot be converted into the equity of the issuing company. Debentures can be convertible too. Convertible debentures can be converted into the equity or shares of the company, after some time, usually at the option of the bond holder. The conversion ratio is specified at the time of selling of convertible debentures. The conversion ratio is the number of shares of the company that will be issued to the bondholder for every unit of the bond or NCD that the bondholder owns.

Features of Non-convertible debentures

Here are features of non-convertible debentures listed below. Knowing these can help in understanding how to invest in NCD:-

1)Credit Standing

Credit Standing, similar to CRISIL, CARE, etc., ranks companies based on their creditworthiness. An advanced credit standing means that the company can fulfil credit scores. Still, a low credit standing means that the company has high credit pitfalls involved. However, the standing agencies give them a lower ranking If any issuing company fails to make payments.

2)Interest Rates

Non-convertible debentures have a pre-decided maturity date. The interest rate can be paid in instalments on a monthly/quarterly/annual basis. The interest rate of non-convertible debentures is decided upon the specified fixed period. However, one can also opt for the collective payout offered by NCD. Usually, NCDs that are not secured offer bigger interest rates.

3)Issuance

Investors can access NCD’s from open market public issues which are done by the company. These debentures can be brought by investors at the designated time and be a part of the company’s fundraising campaigns.

4)Exchangeable Securities

The stock market often sees trades of non-convertible debentures. This improves market liquidity since investors can buy and sell NCD’s flexibly and helps investors to keep a diverse portfolio.

5)Rating Credits

Companies with good rating credits can invest in NCDs since they do not have any collateral backing. These credits are an important indicator for investors since they tell whether a company can or cannot fulfil its credit obligations. These credits are crucial when issuing and looking to invest in NCD.

Types of non-convertible debentures

Non-convertible debentures are of two types – Secured and Unsecured.

1. Registered NCD’s
   In registered NCDs, only the person in whose name, the debenture is registered will have the right to receive the interest and principal payments.
2. Bearer NCD’s
   In the case of a bearer NCD, anybody who is in possession of the NCD will have the right to receive the interest and principal payments on the NCD.

NCDs can also be classified as redeemable or irredeemable.

• Redeemable debentures have a specific date of maturity. On the date of maturity all the principal is paid back to the debenture holders.
• Irredeemable NCDs are perpetual in nature. This means that interest on them is paid forever but there is no maturity date, on which the principal amount will be paid back.

How to purchase NCDs?

The process to purchase NCD’s is quite simple. The issuing company commences an open advertising to invest in NCD’s (Non-Convertible Debentures) for a foreordained length. At the end of this advertising, all the NCD’s are recorded on an assigned stock trade that is indicated by the company. Once recorded, the speculators can invest in NCD’s through any enlisted broker or other approved channels that give access to the stock market.

Key features of NCDs

Key features of NCDs are:

• They are non-convertible in nature. They cannot be converted into the equity or shares of the company at a later date.
• They are usually issued for a long term.
• They are unsecured. They are not secured by any specific collateral or security.
• NCDs are debt that the issuing entity owes to those who have bought the NCDs. The issuer therefore has the legal obligation to pay back the interest and principal to the NCD holders, when they become due. If the issuer fails in doing so, then it will be rendered bankrupt. Its assets can then be sold to pay the amount due to NCD holders.

Key benefits of NCDs:

• Interest income can be earned through investment in NCDs.
• NCDs issued by companies that have investment grade credit ratings are quite secure in nature. They have low or negligible credit risk. Credit risk is the risk of the issuer company not being able to pay back the interests or principal on the NCDs, when they become due.
• Credit risk is high in case of NCDs issued by companies with low credit ratings. To compensate for this higher credit risk, these NCDs pay a higher interest rate.
• Some types of NCDs, like those issued by governments, may have some tax benefits too.

Key factors to consider before investing in NCDs

Before looking to invest in NCD an investor should consider the following factors:-

1)Debt Levels

It is important to consider the debt levels of the issuing company. Servicing debt would be difficult for a company if they are facing high levels of debt. Checking the debt-to-equity ratio is important before looking to invest in NCD.

2)Capital Adequacy Ratio

The calculation of the amount of bank capital along with risk-weighted assets is called CAR. It indicates the stability and financial strength of a bank. The higher the CAR, the stronger the bank to resist losses. Checking the CAR is a prerequisite for investing in NCD

3)Non-Performing Asset Provisions

Loans or advances in default are called Non-Performing Assets (NPA). The issuing company makes provisions for NPA’s that need to be checked. A greater provision shows how equipped the company is to manage NPA’s.

4)Interest Coverage Ratio

Meeting interest obligations is measured through Interest Coverage Ratio (ICR). The cost of interest is divided by the earnings before interest and taxes. A high ICR shows that a company can cover up its debts. If an individual is looking to invest in NCD, they should check the ICR of the issuing company.

How does investment in NCDs work?

Most NCDs are now issued in demat form. Demat means dematerialized or electronic form. So you need to have a demat account with a broker such as IIFL Capital Services in order to buy NCDs when they are first issued by the issuing company or entity. The application process is almost similar as that for stocks or other securities. Your application is supported by blocked amount (ASBA). This amount is released from your account and paid to the issuer company when the NCDs are allotted to you.

Each NCD has a face value. The face value is the principal amount that the issuer owes to you. An NCD can be issued by the issuer at a price more than the face value, equal to the face value or less than the face value. Usually, the price at which an NCD is issued by the issuer company is equal to the face value. The face value of one NCD is usually Rs 1000. There is also the coupon rate that will be paid on the NCD. This coupon rate is the periodic interest rate that the issuer entity will pay to those who invest in the NCD.

You can also trade in NCDs that are listed in secondary markets, such as the various stock exchanges. This trading can be done through your trading account with IIFL Capital Services.

Conclusion

NCDs are unsecured debt securities. Investment in them could offer good diversification to those who also invest in equities. NCDs of investment grade issuers are also a secure form of investment.

Frequently Asked Questions

Q1. What is the Put option in an NCD?

A put option in an NCD gives the right to NCD holders to get the NCD redeemed at a time before its maturity. This means that an NCD holder can ask the issuer to pay the principal owed to him back, before the date of maturity, by exercising the put option. Not all NCDs carry put options. The put option feature in an NCD increases the value of that NCD for investors in that NCD. These NCDs are also known as putable NCDs.

Q2. What is the Call option in an NCD?

The call option in an NCD gives the right to the issuer to redeem the NCD before its maturity date. This means that the issuer can pay back the principal due on the NCDs before the maturity date. The presence of the call feature increases the value of the NCD for the issuer. Not all NCDs carry the call option feature. Those that carry it are known as callable NCDs.

Q3. Is NCD better than FD?

Individuals can look to invest in NCD over an FD. This is because it provides a higher interest rate than FD’s. However, it also poses a great threat since the returns are dependent on the financial performance of the issuer.

Q4. Can we sell NCD before maturity?

People who invest in NCD have options to sell them before maturity. This is because NCDs can be exchanged in the stock market. This arrangement ensures individuals have liquidity as well as flexibility that helps them to manage their NCD.

Q5. Are Non-Convertible Debentures tax-free?

No, non convertible debentures are not eligible to be tax-free. According to laws, even selling an NCD will also cause the total amount to be taxed. The amount could be under the category of either short-term or long-term capital gains.