Non-Convertible Debentures (NCDs) & their Valuation Methods

What are Non-Convertible Debentures?

Non-Convertible Debentures (NCDs) are essentially a type of debt instrument that offers a fixed return to the investor with a specified repayment timeline and cannot be converted into equity. NCDs greatly benefit investors as they offer assured returns, low risk, and tax benefits for investors. There are two primary subcategories:

Secured NCDs

Secured NCDs are backed by property or other assets that are used as security for a loan to the corporation (referred to as the “issuer”). Prior to paying bondholders’ interest or other debts, the issuer must repay these loans.

Unsecured NCDs

Unsecured NCDs are not secured by assets or other forms of collateral. Instead, it is dependent on the issuer’s creditworthiness and capacity to compensate investors in the event of a business operation failure. For instance, a decline in profits would have an impact on the issuer’s capacity to make interest payments on schedule without going into default.

How can a company issue NCDs?

A company can issue NCDs either through private placement or a public issue mechanism. Most companies nowadays extensively use private placement mechanisms.

Under the private placement mechanism, companies identify a select group of investors and raise finances by issuing them a private placement offer letter. The investors are also assured of their returns due to the fixed repayment timelines attached to NCDs

Terms & Conditions for issuance of NCDs

Eligibility:

Generally, there are no specific eligibility criteria for companies to issue NCDs on a private placement basis. However, the subsequent listing of the NCDs is subject to the eligibility criteria specific to the respective stock exchange. The eligibility requirements related to the National Stock Exchange of India Ltd. (“NSE”) are listed in the table below:

Expenses and Fess:

Factors that help determine the fees and expenses incurred in the issuance and listing of Non-Convertible Debentures include the company location, value of securitized assets, fees payable to legal and financial advisors, and stamp duty payable. If the company proposes to list NCDs issued through private placement on the stock exchange, then the applicable listing fees depend on the issue size and the applicable fees of the stock exchange where it is proposed to be listed.

Coupon Rate:

According to a review of the most recent private placement memoranda and term sheets, issuers are offering a coupon rate in the range of 8% to 12% on the issuance of NCDs through private placements.

Interest

The coupon rate is predetermined when NCDs are issued. Except in cases of restructuring or redemption, the coupon rate won't vary over the course of the bond's existence. For instance, if an NCD has a five-year maturity date and a coupon rate of 10%, the yearly interest will be 10% for each year the NCD remains outstanding.

Credit Rating

The ability of the issuer to fulfil its commitments is indicated by the credit rating of the NCDs. These ratings are based on various factors, including financial performance, debt levels, industry outlook, and management quality. A lower rating signifies higher risk and vice-versa.

No TDS

According to Section-193 of the Income-tax Act, 1961, NCDs are given in DEMAT form and are listed on a stock market as such not subject to Tax Deduction at Source (TDS).

Liquidity

NCDs can be considered relatively liquid as they are listed on the stock exchange. Some NCDs might also have a built-in clause or an attached put option that allows premature exit to the investors.

Tenure

NCDs are issued with different terms, allowing investors to choose an option that aligns with their investment goals and risk profile.

Valuation Methods for NCDs

Income Approach

Discounted Cash Flow (DCF) Analysis or Capitalization Method.
The valuation of non-convertible debentures under this method involves determining the value of the debentures based on the future cash flows they are expected to generate adjusted for the issuer’s credit risk. This method calculates the present value of the cash flows by discounting them at an appropriate discount rate. The following points must be considered while using the capitalization method to value non-convertible debentures:

Cash Flow Estimation: The future cash flows should be estimated based on the terms of the debentures. This includes considering the interest payment amounts and frequency, as well as the principal repayment at maturity. It is important to use realistic and reliable assumptions when estimating these cash flows.
Redemption Feature: The process of determination of the present value of a debenture is dependent upon the term or maturity of the instrument. Redeemable Debentures have a defined term or maturity whereas Irredeemable Debentures have indefinite term or maturity till perpetuity.
Credit Risk Adjustment: Since debentures are debt instruments, there is always a certain level of credit risk associated with the issuer. To account for this risk, the estimated cash flows should be adjusted to reflect the probability of default by the issuer. This adjustment is typically done by applying a credit spread or discount to the cash flows.
Discount Rate: To calculate the present value of the estimated cash flows, a discount rate is applied. The discount rate represents the required rate of return for similar investments with similar risk profiles. The investor’s expectations are reflected in Yield to Maturity of comparable debt instruments. It takes into account various factors such as the prevailing interest rates, market conditions and the riskiness of the investment.
Sensitivity Analysis: It is recommended to perform sensitivity analysis by using different discount rates to assess impact of changes in the discount rate on the valuation of the debentures. This can help evaluate the sensitivity of the valuation to changes in the market conditions or risk perception.

Market Approach

Under this method the NCD being valued is compared with similar NCDs that are already trading in the market. The valuation is based on the prices or yields of these comparable NCDs. Factors such as credit rating, coupon rate, tenor, and market conditions are considered when selecting comparable NCDs.

Risks Associated with the Valuation of NCDs

When valuing non-convertible debentures (NCDs), there are several risks that should be taken into consideration. These risks include:

Interest Rate Risk: Changes in interest rates can significantly impact the valuation of NCDs. When interest rates rise, the value of NCDs with fixed interest payments typically decreases, as investors may seek higher-yielding alternatives. Conversely, when interest rates decline, the value of NCDs can increase.
Credit Risk: NCDs are debt instruments issued by companies, and there is always the risk of default or downgrade in the credit rating of the issuer. Higher credit risk can lead to a higher required yield or discount rate, which would lower the valuation of the NCD.
Liquidity Risk: NCDs may not always have an active market, making it challenging to determine their fair value. In illiquid markets, it may be difficult to find buyers or sellers, which can impact the accuracy of the valuation.
Market Risk: NCD valuations can be influenced by broader market conditions, such as overall economic conditions, financial market volatility, and investor sentiment. Uncertainty and market fluctuations can impact the valuation of NCDs.
Call or Prepayment Risk: Some NCDs might have a callable feature, which allows the issuer to redeem the debenture before maturity. If the issuer decides to call the NCD, investors may face reinvestment risk if they cannot find another investment with similar or better terms. This can affect the valuation of the NCD.
Event Risk: Events like mergers, acquisitions, regulatory changes, or other corporate actions can impact the valuation of NCDs. Investors need to consider the potential impact of such events on the issuer’s financial health and ability to meet its obligations.

These risks may also vary depending on the issuer, market conditions, and other factors. Analysts need to carefully evaluate and mitigate these risks when valuing NCDs.

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