Types of Interest Rates On Debentures: The debentures may offer fixed or floating rates of interest. Floating rate debentures provide a spread above or below an underlying benchmark rate e.g. RBI Repo rate. Interest is payable on specified dates at the benchmark rate as increased or decreased by a certain spread. Rate of interest payable under floating rate debentures keeps on changing in tandem with the underlying benchmark. Floating rates protect investors against increase in the market interest rates but offers poor protection against fall in the benchmark rate. Hence, the investors must remember that the floating rates are better only in an increasing interest rates scenario whereas in a falling interest rates scenario, fixed rates are a better choice.
Put and Call options: Debentures may have an inbuilt “put” option or “call” option or both. Under a “call” option, the issuing company can exercise an option to redeem debentures before maturity, on expiry of a certain period at a predetermined price. Under “put” option, holders may obtain redemption before maturity at predetermined
price on expiry of certain period(s). “Put” option is better from investors’ perspective as they can choose between staying invested or claiming redemption.
Credit Ratings: Credit ratings are an indicator of safety of investment. As per SEBI guidelines, all debenture issues with maturity of 18 months or more must be compulsory credit rated. Other provisions are:
i) Issues with maturities below 18 months can also be optionally got rated by companies.
ii) Credit rating must be current at the time of debenture issue.
iii) CRAs must monitor the ratings issued by them and changes, if any, disclosed through public notices published in newspapers and their websites.
iv) Credit rating should not be more than six months old as on the date of roll-over, if a company decides rolling- over the debentures on maturity.
Other SEBI Guidelines on Issue of Debentures:
i) SEBI guidelines do not prescribe any minimum or maximum maturity for NCDs. For partially/ Fully Convertible
Debentures, the maximum maturity is 36 months unless the conversion is optional and a “put” option is available to debenture-holders on completing 36 months, or before.
ii) Companies issuing NCDs of maturities greater than 18 months must create a Debenture Redemption Reserve.
iii) Company desiring to roll-over the debentures on maturity must provide a “put” option to debenture-holders.
iv) Resolutions passed by a company for rolling-over existing debenture issues must be vetted by SEBI.
v) Prospectus must clearly indicate the details of listing arrangements, if any, stating unit amount, lot-size etc.
How To Mitigate Your Risk:
- Invest only in credit rated debenture issues from listed companies.
- Investment in secured debentures is relatively safer.
- Avoid investing in debentures of a company with a default history.
- Read the prospectus carefully to check credit rating and level of safety it indicates.
- Avoid investing in NCDs with credit rating just at investment grade, if the company does not have good fundamentals.
- Invest only if you have funds to spare for the entire tenure of NCDs since exiting pre-maturely may not be possible unless the issue is listed. Listing of debentures is not mandatory but at the option of a company.
- Issues with ‘put’ options are better from investors’ perspective, other things remaining the same.
Interest receivable on debentures and CFDs is fully taxable as income from other sources. Premium or bonus received at the time of redemption of debentures is taxable as long- term capital gains if the debentures were held for 12 months or more and treated as short-term capital gains if held for less than 12 months. Short-term capital
gains are included in the gross total income and taxed at the income tax rates applicable for the investor. For long- term capital gains, the investor has the option of paying tax @10% without indexation benefit and 20% with benefit of indexation. Profits on selling of shares received under conversion of PCDs and FCDs are also considered capital gains and taxed as stated above.