What it means
A debenture is a loan that an investor makes to a company, usually backed by the company's general creditworthiness and sometimes by specific assets. The company promises to pay interest at regular intervals and to repay the principal (the original amount lent) on a set date.
A non-convertible debenture keeps that simple structure and, unlike a convertible one, can never be exchanged for shares. Because the investor gets no share of future growth, the interest rate must be attractive enough to compensate for the risk.
NCDs usually pay a higher rate than bank deposits of similar length, and the rate rises with the weakness of the issuer. Credit rating agencies grade the risk so that investors can compare issues.
Companies, particularly non-bank lenders in India, issue NCDs to raise medium-term funds from the public or from institutions. They are listed on stock exchanges in many cases, which gives investors a way to sell before maturity, although trading can be thin and prices may be lower than the face value.
In the United States and other markets, NCD can instead refer to a negotiable certificate of deposit. This is a time deposit with a bank, usually in large denominations, that can be traded in the secondary market.
The meaning of the abbreviation should therefore be checked from the context before comparing figures. Risks are the usual fixed-income ones.
The issuer might fail to pay interest or principal, market interest rates may rise and push the price of existing debentures down, and secured issues may still recover less than the full amount if the collateral is worth less than expected. For a finance reader, the key practical measures are the coupon (the stated annual interest rate), the yield (the return based on the price actually paid) and the credit rating.
A debenture trading below face value will offer a higher yield than its coupon, and one above face value will offer less.
In practice
Real-world examples.
Example
A non-bank lender needs three-year funds to expand its loan book and issues secured NCDs paying 9% a year. Retail investors and mutual funds subscribe, and the lender uses the proceeds to make new loans at higher rates.
Example
A retiree wants a regular income and chooses a highly rated NCD paying quarterly interest. She accepts that her capital is locked in unless she can sell on the exchange, and she checks that the rating is strong.
Example
A corporate treasurer in the United States buys a negotiable certificate of deposit worth $1,000,000 from a large bank. She plans to sell it in the secondary market if the company needs the cash before maturity.
Formula
Calculation
Annual interest = Face value x Coupon rate
Current yield = Annual interest / Market price
Worked example: an investor buys 100 non-convertible debentures with a face value of $1,000 each, at a coupon of 9% a year.
Total face value = 100 x $1,000 = $100,000
Annual interest = $100,000 x 0.09 = $9,000
If the debentures trade in the market at $950 each, the amount paid is 100 x $950 = $95,000.
Current yield = $9,000 / $95,000 = 0.0947, or about 9.5%.
At maturity the investor receives back the full $100,000, so buying at $95,000 also produces a $5,000 gain on redemption.Case study
Seen in the real world.
Greenfield Housing Finance is an illustrative, fictional lender that issued $50,000,000 of five-year secured NCDs at a coupon of 9.5% to fund home loans. The proceeds were lent out at an average rate of 12.5%, giving a gross spread of 3%.
During the second year, a general rise in interest rates meant new debentures of similar quality offered 10.5%, so the market price of Greenfield's existing NCDs fell below face value. Investors who held to maturity were unaffected, but those who needed to sell early took a loss.
In this illustrative story, the company's finance team used the episode to explain the difference between coupon and market yield in their investor briefing. They also arranged a market maker to improve trading in the debentures.
Watch out
Common mistakes.
- Assuming an NCD is as safe as a bank deposit, when it carries the credit risk of the issuing company.
- Confusing coupon with yield, when the return depends on the price paid for the debenture.
- Forgetting that NCD can also mean negotiable certificate of deposit, which is a different instrument.
Questions
People also ask.
What does non-convertible mean?
It means the debenture can never be exchanged for shares of the issuing company, so the investor earns only interest and the return of principal.
Are NCDs secured?
Some are secured against company assets and others are unsecured, and secured issues usually pay lower rates than unsecured ones for the same issuer.
How are NCDs taxed?
Tax treatment depends on the country and investor type, so an investor should check the local rules on interest income and gains on sale.
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