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Higher rate, higher risk

With banks slashing interest rates on fixed deposits, investors are looking at corporate debt as an alternative. But these instruments are more risky than the bank FDs.

These are bad days for investment. Wealth creation is not on most investors' mind; with an erosion of over 50% in portfolio values, they are too busy trying to protect the wealth they are left with. Most investors are making a beeline for the hitherto scorned bank fixed deposits. However, with RBI cutting the benchmark interest rates, banks too have trimmed their deposit rates. So the State Bank of India, which until two months ago was offering 10% on a 1,000-day FD, has now pegged it at 9%.

So where can the beleaguered investor go? To what is possibly one of the last few lucrative investment options: company fixed deposits. Of late, owing to the tightening liquidity and the increasing risks attached to businesses, banks have become wary of lending to corporates. This has resulted in these companies tapping the retail market to fund their expansion plans.

Corporates paying 10% and above
Company Interest (%)
Gabriel India 12
Jaiprakash Associates 12
JCT Limited 12
Shriram Piston & Rings 11.5
Shriram Transport & Finance 11.5
Jindal Steel & Power 11
Madras Fertilisers 11
Tata Motors 11
Triveni Engineering 10.75
Ceat Ltd 10.5
Kerala Tran Dev Fin Ltd 10.5
Dewan Housing 10.25
JK Industries 10.25
Exim Bank of India 10
JK Laxmi Cement 10
JK Paper 10
LIC Housing Finance 10
TV 18 12

So, what do you get with a corporate FD? More risk than a bank deposit, for one. This is because there's no government backing, nor is the investment amount protected under the Deposit Insurance Act (up to Rs 1 lakh in case of bank FDs). "An investor should look at the pedigree of the management and the fundamentals of the company," says Dipen Shah, vice-president, PCG Research, Kotak Securities. Having learnt from the Satyam imbroglio, numbers can be fudged, but if the reputation of the management and its credibility is strong, then an investor's interest is likely to be protected. "It is equally important to look at financial indicators like the interest coverage ratio, the debt-to-equity ratio and the free cash flow generated by the company," adds Shah.

The interest coverage ratio will tell you whether the company can fulfil its interest obligations. Typically, look for a ratio of 2:1 and be sceptical of anything above this. Likewise, the debt-to-equity ratio of a company will tell you how leveraged the company is. Several industries require capex, which may increase their ratios, but a gearing of 1-1.5 is acceptable, says Shah. Lastly, the free cash flow generated by the company will reveal the amount available for repayments. "Though one cannot rely only on these, one should look at the credit ratings assigned to these companies," says Gaurav Mashruwala, a certified financial planner. Typically, look for a rating of BBB or above this.

Here's how you can actually use the above pointers. Take Tata Motors. The company is raising money from the market to fund its recent acquisition of Jaguar Land Rover and to meet its capex requirement. It is offering 11% on a three-year FD; shareholders, employees and senior citizens get an additional 0.5%. Like bank FDs, the company will deduct tax at source if the interest exceeds Rs 5,000 in a financial year, at 10.3%, including surcharge.

The company's debt-to-equity ratio is expected to be more than two times going forward; in the last quarter, Tata Motors posted a net loss of Rs 200 crore for the first time in seven years. The company's debt rating too has been reduced by Crisil, reflecting the impact of the weakening business environment on the company's global and Indian operations. Sounds like a bad bet, doesn't it? But take a look at this.

ratings, Crisil, says, "The downgrade does not mean that the company is not in a position to repay; its rating has been brought down from higher safety to adequate safety." Also, the company's strong management and an impeccable track record provide confidence to investors, adds Shah. Crisil also believes that the measures undertaken by Tata Motors to contain costs and manage its working capital requirements will ease the pressure on its financial risk profile. The group has on tap its non-convertible debentures by Tata Capital, which offers an interest rate of 12% with an AA+ rating assigned by Icra. Typically, debentures are considered safer as they are secured against a firm's assets unlike FDs, which are unsecured.

So, the positives may outweigh the negatives in this case. The deposit is attractive for investors in the highest tax bracket as the posttax yield still works out to 8%. The closest comparison to this option is the Public Provident Fund, which offers a tax-free return of 8% and qualifies for deduction under Section 80C; a corporate FD is not eligible for such a deduction.

There are various other companies offering deposit rates of 10% and more, but each company's balance sheet should be scrutinised before you invest, says Mashruwala. Shriram Transport Finance is offering a rate of 11.5% on a three-year deposit. Given the company's market leadership position and well-entrenched business, analysts believe that the company will deliver 38% CAGR over the next two years, with an average return on equity of 27%. These are good numbers to reckon with.

The point to remember is that corporate FDs are as risky as the company itself. In general, government undertakings are the safest option since they come with a sovereign rating. Financial institutions are also good bets as they have proven risk aversion measures and high capital adequacy ratios, followed by manufacturing companies. The NBFCs could be a little risky due to their past commitments, leading to high NPAs.