When we assess the various fixed income options available, we find that company fixed deposits (CFDs) usually fall in the high return-high risk quadrant. A CFD is usually sought after by investors whenever a low yield regime is prevailing. During such times, the hunger for yield makes investors gravitate towards this option. However, the current environment is one where investors are able to lock into reasonably high yields through relatively safer instruments such as bank fixed deposits or debt mutual funds. Therefore, CFDs may not be the best option in today’s times. Here are a few salient features as well as a few suggested safeguards that could be undertaken while investing in CFDs.
CFDs are unsecured instruments: Unlike a bank fixed deposit, which is usually guaranteed by the Reserve Bank of India (RBI) up to a sum of Rs 1 lakh (subject to certain conditions), or corporate debentures/bonds, which are often secured against certain fixed or floating assets of the issuer, CFDs are unsecured instruments. Therefore, CFD holders are heavily reliant on the cash flow of the issuer for the timely receipt of interest and principal. Besides, they are also more prone to moral hazard on the part of certain issuers who despite being able to pay, may still try their utmost to delay payments merely because they know that CFD holders are lower down the pecking order and are usually an unorganised lot as compared to institutional creditors.
Check the ratings: There are two major categories of companies that raise fixed deposits ? Non-Banking Finance Companies (NBFCs) and others, which include manufacturing companies and real estate companies. According to the RBI, NBFCs that offer FDs have to mandatorily procure a credit rating from one of the approved rating agencies such as CRISIL, ICRA and CARE. For NBFCs, RBI has made it mandatory to have an ‘A’ rating to be eligible to accept public deposits. However, this is not mandatory for the second category.
The safety regarding timely payment of interest and principal reduces as the rating reduces. CRISIL’s fixed deposit ratings range from FAAA downwards. In addition, they also state their outlook on the company, which could be Positive, Stable or Negative. Often, these ratings serve as the only guide that an investor may have, as he is usually not privy to the updated financials of the company which banks and other large lenders may have access to. While non-NBFCs are permitted to raise CFDs without undergoing the rating process, most reputed companies opt for a rating. Bajaj Auto, Tata Sons and HPCL are three prominent companies whose FDs are rated. As a rule, choose a rated CFD over an unrated one. Also, it is preferable to choose CFDs which are rated AA or above.
Choose shorter term deposits: When you lend money to a company through a CFD, you are implicitly taking a call on the borrower’s financial and credit standing. Purchasing long-dated CFDs will increase your risk, especially in the case of companies prone to cyclical ups and downs. Therefore, it is preferable to choose CFDs with a tenure of one year to three years.
Do not go by yield alone: It is natural that companies with weaker financial standing will offer you higher yields at any given point in time. Be wary of companies which offer a huge premium to the prevailing rates. However, other things being equal, when comparing two similarly rated companies, you may choose the one which offers a higher yield. Also, look at the post-tax yield you receive, as CFDs do not enjoy the benefit of any tax shelter.
Integrate CFDs into your overall plan: Usually CFDs offer around 150 basis points above comparable bank FDs of similar tenure. Sometimes the high yields may tempt you to over-invest in CFDs. However, it is important that you do not alter your broad asset allocation while doing so. Even within your overall debt allocation, it is preferable not to invest more than 25% in CFDs given their higher risk profile and poor liquidity as compared to bank deposits and debt mutual funds. Also, do not invest over 5% of your portfolio in companies which offer you abnormally high yields.
* The author is vice-president, Parag Parikh Financial Advisory Services
