5 filters to choose high-yield NCDs

High-yield NCDs are all the rage! With business booming and interest rates at a high, the Indian market has suddenly become flush with NCDs, mostly from NBFCs. (What are NCDs? Read this). 

New online bond platforms are wooing investors to ‘high-yield’ NBFC NCDs offering a mouth-watering 11-13% per annum. When given a menu of NCDs from unfamiliar names, you may be tempted to go for the one with the sky-high yield. But in the debt market, high yields almost always go hand-in-hand with high risk. A 13% payout on an NCD will leave you cold, if the company were to fold up before maturity. 

So how do you choose NCDs that earn a good yield while minimising risk? 

How to filter the NCDs

#1 Know the business 

As an investor in a NBFC NCD, you’re effectively lending money to the business. Therefore, it is important to know the end-use your funds will be put to. Do a bit of browsing and digging to know whether the NBFC is lending against collateral (loans against gold, property, vehicles) or without it (personal loans). Check whether the collateral is an appreciating asset (gold, property) or a depreciating one (trucks, two-wheelers, cars). In both cases, the second business is riskier.  

The riskier the NBFC’s loans, the higher the yield it is likely to offer. Therefore, you may want to settle for a gold loan NBFC over a microfinance one, even if the microfinance one offers a better yield. A microfinance NBFC (a regulated business with a well-defined business model) may be safer to invest in, than a fintech firm that offers payday loans to cash-strapped individuals or NBFCs that offer business loans (no clear end use). 

Some credit models in India have been tested over multiple economic cycles. Home loans, SME Loans, gold loans, microfinance loans, new and used commercial vehicle loans fit this description. So NBFCs that have been operating in these segments over the past two decades have honed their risk management practices over time. Such issuers are safer than new-age NBFCs that deliver credit to hitherto unbanked or new segments of the population. 

When assessing an issuer’s business, it helps to be sceptical. In the ‘About Us’ section on its website, one NCD-issuer simply says that it provides secured loans to entrepreneurs and self-employed people for business purposes and asset creation, at say ticket sizes of Rs 1 lakh to Rs 10 lakh for upto 7 years. This packs in far more relevant information than a company which showcases multiple awards for innovation, waxes eloquent about AI and promises fast sanctions with minimal paper work – this may good for loan-takers but certainly not for investors in the company’s bonds. 

#2 Time the cycle 

Every lending business in India goes through cycles, depending on the ups and downs of the borrower segment it caters to. Some segments face sharper upheavals than others. For instance, we know that even in the worst of times, gross non-performing assets (GNPAs) in home loans have never exceeded 2%, while vehicle loans can see a spike in GNPAs above 5 % and microfinance loans can approach double-digit GNPAs. As an NCD investor,  it is safer for you to invest in NBFCs lending to the sectors that are more resilient to cycles, especially if your time frame is long.

At the early stages of a positive economic and business cycle, even NBFCs operating in riskier sectors may be okay to invest in. In a slowdown scenario, it may be best to stick with NBFCs in resilient businesses. RBI’s six-monthly Financial Stability Reports have good data relating to the sector-wise NPA picture for banks. You can safely assume that the NPAs for NBFCs in the same sectors are likely to be higher.  

#3 Pedigree over security in high-yield NCDs

Textbooks tell you that NCDs that are defined as ‘senior and secured’ are safer than those that are subordinate and unsecured. But in the Indian context though, the pedigree of the issuer who is offering you the security is more important. Dewan Housing Finance NCDs on which investors were forced to take large haircuts were senior, secured bonds. 

Timely servicing of any loan depends not just on the ability of the borrower to pay (which depends on the health of the business) but also their willingness to honour their obligation (which depends on ethics). When a bank or NBFC defaults and is dragged to Insolvency Court in India, skeletons often come tumbling out of the closet on related party loans, siphoning of funds and over-stated assets. In such cases, the collateral can prove to be an ephemeral comfort. 

However, if the promoter of the lending institution cares about his or her reputation, he or she is likely to ensure that lenders are paid in full. In the Indian context, this makes an unsecured NCD from reputed business houses like the Tatas, Birlas, Murugappa, HDFC etc a safer bet than secured NCDs from newly sprung-up NBFCs even if backed by marquee private equity names or big-ticket foreign funds. The former have a reputation to defend, as they have significant domestic business interests. For PE funds or investors, the shareholding in the NBFC may be just one of many risky bets.  

#4 Listed over unlisted NCDs

With NCDs, as with stocks, one cannot take the “fill it, shut it, forget it” approach. The sector or the NBFC’s business can go downhill at any time during your holding period and this can up the riskiness of your investment. To know if this is happening, you need regular financial disclosures from the company. Such disclosures are only available if your NCD is listed on bourses (or if the issue is listed).   

NCDs in India can come both from unlisted and listed companies and can in turn, either be listed on the exchanges or unlisted. Only listed NCDs come under SEBI’s purview (unlisted ones are overseen by the Corporate Affairs Ministry). These are subject to stringent disclosure rules. Therefore, given the choice between unlisted and listed NCDs, it is best to stick only with the latter. Listed NCDs also make it possible for you to explore early exit through the exchanges if you need the money, or if risks shoot up. Yes, not all listed NCDs trade regularly, but they give you a better shot at premature exit than unlisted ones. 

#5 Think in spreads, not absolute yield 

Is a NCD offering a 13% yield better than one with 10%? You really can’t say because the yield only captures the return element of an NCD. Its doesn’t tell you anything about the risk. To make good decisions on investing in NCDs, you need to assess whether the yield it offers compensates for the risk you’re taking on. The risk in any debt instrument can come from two sources: credit risk - the possibility of default or delays in repayment and interest rate risk – the possibility of interest rates moving up while you’re locked into a fixed rate. 

When assessing the yield of a NCD, therefore, you need to look at it through the lens of the credit and rate risk you’re taking on. So, a NCD offering 10% may actually be better than one offering 13% if it is for a shorter tenure and from a more pedigreed issuer. 

To assess whether a high-yield NCD is compensating you adequately for credit and rate risks, you need to be aware of the spreads (extra yield over the government security) that NCDs of a similar credit rating and tenure are offering in the market.  The table below shows the latest available yields on corporate bonds across the rating scale. 

The above table tells you that, with the government of India offering 7.18% on its bonds, its no big deal if private sector NCDs offer 8% today. If a somewhat risky NBFC with an AA credit rating is offering 9.5% on its 5-year NCDs, that’s not a really a steal, as the market yield for that bond comprising of both PSUs and other issues is now at 9.42%.  

While assessing the yield on any NCD, evaluate if the spread is enough to make up for any extra risks in the business or sector. When making such comparisons, don’t forget to assess the NCD against market instruments of similar tenure. Longer the tenure of the NCD, the higher the yield you should be getting to make up for rate risks. Also be aware that, as you go down the credit rating scale, the default risk shoots up disproportionately. Therefore, an A-rated issuer is many times riskier than an AAA issuer and the yield offered must compensate for this risk. 

Managing risk

Even after putting in all this homework though, NCD investments can sometimes go rogue. Apart from defaults or delays in payment of interest and principal, there’s the possibility of credit downgrades weighing on the market price of the NCD you’ve invested in. You can manage the risk to your portfolio from such events in four ways. 

Diversification: You can cap your allocation to high-yield NCDs at a portion of your debt portfolio and spread this allocation across multiple issuers.  

Tenure: Longer tenure NCDs carry more rate as well as credit risk. The rate risk arises from market interest rates embarking on a new upcycle. The credit risk arises from the sector or business going into a downturn after you invest. Most of the riskier lending businesses do not offer visibility on how the sector or NPA picture will pan out beyond 3-4 years. Therefore, the best way to contain risks in such NCDs is to go in for shorter tenures of up to 3 years, that offer better business visibility. 

Put/call options: If the NCD comes with a put option, it will provide you with an early exit option, in case you perceive higher risks. An NCD with a call option allows the issuer to redeem the NCD prematurely and pay back your money. 

Payback mode: Opting for the regular payout option of an NCD helps contain risks compared to the cumulative option, because you get periodic return of your money from the issuer, instead of locking it all up until final maturity. Some of them also offer payout of principal amount on a equated instalment basis. This is even better when the risk is high.

At PrimeInvestor, we use these filters to pick moderate risk and high-risk bonds based on the opportunity and risk-return trade off. You can check them in our Prime Bonds section. Prime Bond recommendations are available for our Growth subscribers.