Non Convertible Debentures (NCDs) vs. Credit Opportunity Debt Mutual Funds

Non Convertible Debentures (NCDs) vs. Credit Opportunity Debt (COD) Mutual Funds

Non-convertible debentures or credit opportunity bonds are securities issued by companies to raise funds. When you buy such bonds, you are actually lending money to the company for a periodical fixed interest (known as coupon). On the maturity date, your principal will be returned to you.

Non-Convertible Debentures:

A NCD is a debt paper (debenture) that is issued by the company for a fixed period.During that period, the company pays a fixed interest. As the name suggests, NCDs are non-convertible and cannot be converted into debentures like stocks on maturity. Instead, the principal and interest is paid to the investor when the debenture matures. They provide a fixed income along with higher returns, which makes it irresistible for investors. There are two types of NCD, secured and unsecured.

In a secured NCD, there is a backup of assets which will be liquidated to pay the investors in case the company is unable to fulfil its obligations. They offer more security but lower returns than unsecured NCDs which do not have any backups in case the company lapses.

Credit opportunity funds:

They are a type of debt mutual funds but the difference is that they invest in less secure market instruments. They use the income from the interest payments of original bonds to invest in several corporate bonds for higher returns. They employ the accrual strategy (bonds are held till their maturity) for higher returns and for minimising interest rate risk.

 

​Differentiating factor  ​NCD ​Credit opportunity debt funds
Tenure

NCDs tenures range from 1, 3, 5 to 10
years, depending on the fund.

Credit opportunity debt funds do not
have a lock in period and can be redeemed anytime

Liquidity

NCDs are highly liquid and the investors are
allowed to exit before maturity. But allowing the security to mature helps in
balancing the interest rate risks involved.

Credit Opportunities Mutual funds can be
redeemed anytime. It has high liquidity and there is no lock in period. But
allowing the fund to stay for three years gives you indexation tax benefit.

Diversification

​NCDs are usually hosted by a single company to
raise money for a long term fund

​Credit opportunities are naturally
diversified as they invest in a blend of companies, thus reducing your exposure
to risk.

Taxation

In NCDs, you will not get any interest if you did not hold the debenture till maturity. If the debenture is sold within 12 months, then the capital gains will be considered as short term and taxed at 15%.
After 12 months, they are considered as long term capital gains and taxed at
10.3%.
On maturity, the profits are added to the income of the investor and taxed according to his tax slab.

​In Credit opportunity mutual funds, if
you redeem within 3 years, then you are taxed according to the tax slab you
fall under. After 3 years, you are taxed at 20% with indexation benefits.

Which option offers you better tax return?

Case 1: NCD

Let us say you hold an NCD for five years at 9%. You fall under 30% tax slab which means you have to pay 9 X 30 which equals to 2.7%. This means that 2.7% of you total income will be taxed away and you will be left with 6.3% as your own. 

Case 2: Credit Opportunity Mutual Funds

Let us now assume that you have held a credit opportunity Mutual Funds at 8.5% for 3 years, thus availing the indexation benefit. When you sell the fund after three years, your taxable income will be the difference between the return and inflation.

Taxable return = Return – Inflation = 8.5 – 5 (Long term average for the past 10 years, published by Govt. of India).

This equals to 3.5% (without inflation).

Now let us consider about the indexation benefit which is 20% of your taxable income. This means that only 20% of your taxable income is actually taxed. That is about 0.7%

Hence, your income is, 8.5 – 0.7 = 7.8% which is the after tax return.

Compared to NCD returns (6.3%), credit opportunity funds offer (7.8%) is actually 23.81% higher than NCDs. i.e. you can earn 1.5% further by investing in Credit Opportunity Mutual Funds (due to their tax arbitrage).

Conclusion:

Both the funds have a similar risk profile that can be balanced by staying invested as long as possible. But based on the example given above, it is evident that credit opportunity debt funds give higher after tax income than NCDs. Also, they are more diversified and tax proficient while offering attractive returns. 

 

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Mutual fund investments are subject to market risks. Please read the scheme information and other related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements before choosing a fund, or designing a portfolio that suits your needs.