A 12.5 per cent annual interest over three years on a fixed deposit
(FD) scheme at a time your bank FD is giving 9.25 per cent seems like an offer that must be grabbed.
The offer looks more lucrative if you consider that your equity portfolio shrinked 10-15 per cent over the last one year. The FD scheme we are talking about has been launched by a company that is into construction, real estate, cement and power generation.MUST READ: Should you invest in fixed deposits or debt funds?
Companies that find it difficult to get loans from banks raise money from the public. Two ways to tap the public is through FDs and non-convertible debentures (NCDs).
The two usually offer one-two percentage point more than bank FDs. However, companies cannot offer more than 12.5 per cent. Attractive rates generate a lot of interest among retail investors scared of investing in the stock market.
COMPANY FDs AND NCDs
Before we go into the pros and cons of company FDs and NCDs, let's look at the difference between the two.Safety:
NCDs are secured debt instruments backed by assets that lenders (depositors) can claim if the company fails to repay them. Company FDs are unsecured and so more risky. Bank FDs over Rs 1 lakh are also not secured by assets.Liquidity:
NCDs are traded on exchanges. Hence, there is an exit route without payment of fine for premature exits. NCDs give investors the option to sell their units back to the issuer after a specific period.
Company FDs are not traded on exchanges but investors can withdraw the money before maturity by accepting 1 per cent less than the promised rate.ALSO READ: Non-convertible debentures offer better returns than FDs Credit rating:
NCD issuers have to get the instruments rated by at least one agency. The rating and what it means have to be mentioned in the offer document. If the issue has been rated by more than one agency, all the ratings have to be disclosed even if the issuer does not approve of any rating.
Corporate FDs do not need any rating. Even if a company gets the issue rated, it is not mandatory for it to disclose the rating.
Bank FD rates vs Company FD rates
Interest earned from NCDs is taxed according to the investor's income tax slab. No tax is deducted at source if the annual interest is less than Rs 2,500.
Proceeds from sale of NCDs before maturity are considered capital gains and taxed accordingly. Short-term capital gains are taxed according to the person's income tax slab. Long-term capital gains are taxed at 10 per cent without indexation.
In company FDs, tax is deducted if annual interest exceeds Rs 5,000. There is no capital gains tax.
COMPANY FDs: THE POSITIVES
Banks are offering 9-9.5 per cent on three-year FDs. After adjusting for tax, the returns are 6.5-8.8 per cent depending on the individual's income tax slab. For many, this is a meagre return.
Someone who is ready to take risk can explore company FDs and NCDs. Company FDs are offering up to 12.5 per cent a year. Post-tax returns are 9.2-11.9 per cent depending on the tax slab. This means a company FD offering 12.5 per cent is giving 2.7-3.1 percentage points more post-tax returns than a bank FD offering 9.5 per cent.
"While the two-three percentage point higher rate than bank FDs may look attractive, it must translate into gains in absolute terms."
Certified Financial Planner
"While investing in company FDs, look for reasons why the company is raising money and where it is going to use it."
Senior manager, Personal FN
The interest on both company FDs and NCDs does not fluctuate and hence the two can be a regular source of income. Company FDs offer investors the option of receiving interest either at regular intervals or at the end of the maturity period. The interest is compounded monthly or quarterly.
The tenure of company FDs can be as low as six months and as much as 10 years. NCDs have similar maturity periods. Bank FDs also have several tenures, some as short as 14 days and as high as 10 years.
The mathematics of return clearly favours company FDs and NCDs. But should you invest your hard-earned money purely on this criterion?
Like in any other investment option, the risk of losing money should be a key consideration while investing in company fixed deposit schemes and NCDs.
In company FDs, the biggest risk is repayment or credit risk. Investors often ignore this because they consider these instruments as safe as bank FDs, which is a grave mistake. There have been numerous cases of little-known companies promising very high returns and failing to repay.
Therefore, before getting lured by attractive interest rates promised by company FDs, you must take a few precautions:Don't fall for very high interest rates:
Avoid schemes that promise very high returns. Companies (Acceptance of Deposits) Rules, 1975, do not allow companies to offer more than 12.5 per cent a year. A company offering more than this may not be authorised to collect money from the public.
Head to Head: Bank FDs, Company FDs and NCDs
The Reserve Bank of India (RBI) keeps warning people about such companies. The RBI publishes on its website (http://rbi.org.in/scripts/BS_NBFCList.aspx) a list of non-banking finance companies (NBFCs) allowed to accept deposits from the public. Investors should avoid investing in deposit schemes of companies not in this list.Check financial health of the company:
All companies raising deposits are required to disclose their net profit and dividend paid for the past three years. They are also required to publish the latest audited balance sheets. Investors must see if the company has made profit in the past three years and paid regular dividends. Companies also have to disclose if they have defaulted on payment to retail investors in the past.
"Always look for reasons the company is raising money and where it is going to use it. If it is utilising the money in a subsidiary company, it's important to find out the financial health of the subsidiary as well," says Dia Kirpalani, senior manager, PersonalFN, a financial advisory company.Look for ratings:
Though not mandatory, some companies get their FD schemes rated. Rating is mandatory for companies issuing NCDs. A very highly rated (AAA+) NCD may be safe but will offer less than a slightly lower rated (AA-) security.
Though company FDs offer better returns than bank FDs, the former has more risk. If you are willing to take that risk, and have done the necessary due diligence, then only invest in company FD schemes.
"While the two-three percentage point higher rate than bank FDs may look attractive, it must also translate into gains in absolute terms. If you are investing Rs 50,000, you will earn only Rs 1,000-1,500 more on company deposits. Post-tax returns will be even lower. Just ask if this gain is worth taking that the extra risk," says Gaurav Mashruwala, a Mumbai-based certified financial planner.