A non-convertible debenture could be secured but retail investors may not be the first in line for a claim if the company goes bust. Invoice discounting is even riskier. Understand the hidden costs in these investments before you commit your money
There is a lot of talk in the media and on social media these days on various guaranteed-return schemes which promise 10-14 percent annual returns. It seems like debt funds have become unattractive after the tax rules on these funds changed this financial year. High fixed returns in products like non-convertible debentures (NCDs), peer-to-peer (P2P) lending, invoice discounting, or asset leasing have caught the fancy of investors. But do these high-returns products come with high risks? Do investors really understand what they are getting into?
How to evaluate your NCD
Just looking at expected returns is not enough. Every investment product needs to be evaluated on these five parameters:
1) Understanding of the product.
2) What is the risk to capital? What could go wrong with the investment?
3) Liquidity – how easy is it to exit the investment?
4) Post-expense, post-tax returns.
5) Is the product regulated?
NCDs may look safe, especially when issued by government-promoted entities or well-known companies, but that doesn’t make them the best investment. The organisation’s credit rating, which tells about its ability to repay, is what an investor must look at.
A secured NCD? Not quite
The fact that NCDs are secured also doesn’t guarantee return of capital. Most of the NCDs being offered include subordinated debt, which means that senior lenders, typically banks and financial institutions, will have priority over liquidation proceeds.
Enforcing the collateral is not easy either, as has been seen in default cases over the last few decades. If the collateral is receivables, the biggest risk is of the business not doing well, and if the collateral is fixed assets, then exiting the fixed assets is time consuming. Further, most NCDs are illiquid and even if they are listed, finding a buyer is not easy.
Applying the parameters
Now let’s look at how to apply each of the parameters:
1) Understanding of the product: Who is the issuer of the NCD and who are they lending to? Is the company a financial services NBFC lending to low-rated borrowers, or, if it is a bank bond, are the terms favourable to retail investors. For example, AT1 bonds which were sold to senior citizens can be written off in case the bank suffers a loss, leaving the investor with nothing.
2) Risk: The company may default or delay payments, especially if it is rated A and below.
3) Low Liquidity: The NCDs might be listed on the stock exchange, but if there aren’t enough buyers or sellers, it might be a problem for those who wish to exit prematurely.
4) Returns are fully taxable: A BBB-rated bond with a gross return of 12 percent per annum will give a post-tax return of 8 percent, which is 300 basis points (bps) more than what a high-quality short-term bond fund can give on a post-tax basis. One basis point is one hundredth of a percentage point. Is 3 percent extra returns worth the risk? For every Rs 1 lakh investment, it works out to Rs 3,000 more, but with huge risks.
In which case, clearly the coupon offered is not commensurate with the rating. This is the cost to the investor.
NCDs are regulated, but products like invoice discounting and asset leasing are not. Yet investors are flocking to these products. Let’s look at the evaluation parameters for some of these trending products:
Understanding of the product
In invoice discounting, the investor lends cash to an entity up to the value of its unpaid invoices (receivables). The entity accepts a discounted amount as it is getting the money earlier than the invoice payout period. The investor then has the ownership of the invoice and the monies receivable against it.
There are investment platforms that provide access to asset financing opportunities- for example financing of solar assets. The investor part-owns the asset, and has a share of the income the asset generates.
In peer-to-peer lending, investors fund individuals who may be unable to access credit from banks and other financial institutions due to low credit scores or lack of collateral.
Investors need to ask themselves if this is how they want to use their monies — by funding individuals with low credit scores, discounting a firm’s invoices, or getting returns from assets which they have no clue even exist (there is no auditing of the assets).
Regulation
Regulation ensures that there are standard disclosures, reporting, and grievance redressal. But what is the recourse on unregulated investments like the ones mentioned above? The platforms which provide these investments are merely distribution channels and will not take the onus in case of any default or delay.
Risk
The above products carry the risk of investing in unknown entities and assets.
Liquidity
The platforms say they will help find buyers for the credit assets you hold, but they are not obliged to do so. Are investors willing to lock into products they cannot exit when they want to?
Costs
Even with post tax returns of 8-10 percent, the risk of the unknown far outweighs the attractive returns. The cost here is the opportunity loss and the risk to capital, which is very high.
The prospect of high returns tends to alter one’s sense of priorities. Investors must always ask these five questions while investing in any product: Where does it put your money, what is the risk, who regulates it, when can it be exited, why is the cost so low (or high)?