NCD – invest with caution

The IIFL NCD issue has opened already on 5 September 2012. I have written about it in an earlier article.

Shriram City Union Finance NCD opens on 12 September 2012. Religare Finvest NCD and Muthoot Finance NCD are expected to open for subscription soon. All of them are NCDs issued by NBFCs (non-banking financial companies).

What is the difference between banks and NBFCs?

Both NBFCs and banks are in the business of lending.

They are regulated by the Reserve Bank of India (RBI).

One key difference is that NBFCs cannot accept deposits repayable on demand. A bank can do so with savings bank deposits. NBFCs can only accept fixed term deposits.

How do NBFCs do business?

NBFCs borrow funds from banks, private entities and the public respectively and lend them onward to retail or corporate customers.

A hypothetical NBFC company X borrows from the bank at 11%. It lends this money at the rate of 18%. The difference between what they earn as interest at 18% and what they pay out at 11% is the net interest income for the NBFC.

Banks and NBFCs are particularly risky entities because they operate with a high amount of borrowings compared to manufacturing companies. That is also why they have a regulator in the form of RBI to oversee their activities.

Down memory lane

First, I would like to ask you to go back 15 years. Anyone who is above the age of 30 will surely remember the word debentures. And mostly, in a negative way.

Why?

Read these articles quickly and come back.

Article from Indian Express – Year 1998

Article from Business Standard – Year 2002

Article from the Hindu Business Line – Year 2002

Clearly, many people lost a lot of money in debentures between 1995 and 2002. Many companies defaulted and people lost money. In fact, debentures was a bad word back then.

This is not to say that things will repeat again. There have been several changes in the regulations through which the authorities are trying to make it a safer place for retail investors.

Summary

Don’t rush to invest into NCDs before you do a thorough analysis. In the next article I will share with you simple principles to make safe debt investments.

Please read the disclaimer.

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