The Concept
As the name suggests, this NCD is not supported by issuer’s assets. Consequently, it involves high risk. In case, the issuer experiences financial hardship, payments to the investors get interrupted. If there is a bankruptcy or insolvency issue, the holders of unsecured NCD are the last to be repaid.
To compensate for this high risk, this type of NCD comes with high-interest income.
The Caution
Unsecured NCD is the last resort for a business entity to raise capital. If they had collateral to support borrowings, they would have simply gone for a loan. So, investors must keep it in mind that the issuer has probably used up all of its assets.
Best Strategy
By allowing NBFCs to issue unsecured NCDs, RBI seems to encourage investment in these instruments. However, since it is an unsecured debt investment, the risk factor must be accounted. The creditworthiness of an NCD is best judged by its rating given by organizations like ICRA and CRISIL in India.
The Rule of Thumb: Any unsecured NCD having lower than AAA rating is risky.
Investors should:
- Hold a small portion of their portfolio in unsecured NCDs.
- Buy from multiple issuers.
- Avoid this type of investment after retirement.
If these NCD’s are so risky then why is it allowed by the RBI? No doubt about the high interest rate. These cannot be used for planning the future or as security. The risk involved is too high so double checking before investing to be assured is worthwhile than just jumping into it.
Hi Vandana,
Thanks for taking time to read the article thoroughly. You have raised a very interesting point. It is true that RBI is giving NBFCs license to issues unsecured NCDs. But it is monitoring the process very closely. There are some very strict criteria that need to be fulfilled in order to get license. For example, RBI checks the credit rating of a NBFC before allowing it to issue NCDs. All these monitoring measures offset the risk associated with unsecured NBFCs to some extent. The rest is upon the investor as in case of any other investment.
Unsecured NSD´s are one of the most expensive financial inputs that a company can obtain on the basis of financial instruments. I suppose action like this is realised when the company really needs the money in order to ˝dodge the bullet˝ and are expecting the money from other sources in a short period of time. Otherwise, things might really go wrong.