A 12.5 per cent annual interest over three years on a fixed deposit, or FD, at a time your bank FD is giving 9.25 per cent, is a very tempting offer. It looks even more lucrative if you consider that your equity portfolio must have shrunk 10 to 15 per cent over the past year, as Indian markets fell sharply.
Many companies offer such fixed deposit schemes, especially when they find it difficult to get loans from banks. There are two ways for companies to raise money from the public - through FDs and through non-convertible debentures, or NCDs.
Both usually offer one to two percentage points more interest than bank FDs. However, companies are not allowed to offer more than 12.5 per cent. Even so, because of the higher rate, FDs and NCDs generate a lot of interest among retail investors scared of investing in the stock market.
Let us first take a look at how company FDs differ from NCDs: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 more risky. Bank FDs over Rs 1 lakh are also not secured against assets.Liquidity:
NCDs are traded on exchanges. Hence, there is an exit route without payment of any fi ne 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 one per cent lower interest than the promised rate.
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.
Interest earned from both FDs and NCD is taxed - as is interest from bank FDs - according to the depositor's income tax slab. For NCDs, tax is deducted at source if the annual interest is more than Rs 2,500. Proceeds from the sale of NCDs before maturity are considered capital gains and taxed accordingly. Shortterm 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 at source if annual interest exceeds Rs 5,000. There is no capital gains tax.Positives of Company FDs
Banks curently offer nine to 9.5 per cent on three-year FDs. After adjusting for tax, the returns are 6.5 to 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 risks can explore company FDs and NCDs. At12.5 per cent interest posttax returns from these would be 9.2 to 11.9 per cent depending on the tax slab. This means a company FD offering 12.5 per cent is giving 2.7 to 3.1 percentage points more post-tax returns than a bank FD offering 9.5 per cent.
The interest on both company FDs and NCDs does not fl uctuate and hence the two can be a regular source of income. Company FDs offer 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 short as six months and as long as 10 years. NCDs have similar maturity periods. Bank FDs also have several tenures, some as short as 14 days and some as long as 10 years.
The mathematics of return clearly favours company FDs and NCDs. But should you invest your money purely on this criterion? As with any other investment option, the risk of losing money should be a key consideration as well.
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 littleknown 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: Do not fall for very high interest rates; avoid schemes that promise very high returns. Since the Companies (Acceptance of Deposits) Rules, 1975 do not allow companies to offer more than 12.5 per cent a year, the ones doing so may not be authorised to collect money.
The Reserve Bank of India issues warnings about such companies. It publishes on its website (http://rbi. org.in/scripts/BS_NBFCList.aspx) a list of non-banking fi nance companies, or NBFCs, allowed to accept deposits from the public. Investors should avoid investing in schemes of NBFCs not in this list.Check financial health:
All companies raising deposits are required to disclose their net profi t 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 profi ts 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 fi nd out the fi nancial health of the subsidiary as well," says Dia Kirpalani, Senior Manager, PersonalFN, a fi nancial 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 the risk, then only invest in company FDs. "While the two to 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 to 1,500 more on company deposits. Post-tax returns will be even lower. Just ask if this gain is worth taking given the extra risk," says Gaurav Mashruwala, a Mumbai-based certifi ed fi nancial planner.
Courtesy: Money Today