Indentifying risks in company FDs
Companies usually offer more in interest than banks. This is not just because banks FDs are so popular, but due to the risks. Higher the rate, bigger the risks.
Bank fixed deposits retain their popularity all year round for two reasons – they’re safe and easy to make. There’s no volatility, so you can be sure returns will be positive and your initial investment is safe. Then, there’s also the fact that even if the bank fails, your money is insured for up to Rs1 lakh. Why then would you invest in company fixed deposits? The main reason is that post-inflation returns from bank FDs are a pittance after tax if you’re in the lowest tax bracket and even non-existent if you’re in the highest. For a small increase in risk, you can get a proportionate increase in returns. Here’s what you need to know before you invest:
Credit rating: To prove their financial standing, many companies will subject themselves to scrutiny from a credit rating agency such as CRISIL or ICRA. As a rule, the better the company is rated, the less you’ll receive in interest. This means that better interest rates mean more risk. Now, what do ratings mean? Investment in a AAA-rated company is considered to have the highest degree of safety, while AA-rated companies are said to offer a high degree of safety. This means the chance of a default is low in both cases. Only the largest companies, such as HDFC, Dewan Housing Finance and Mahindra Finance, receive these ratings, which is why they offer lower rates of interest, not much better than the best bank rates. Companies that could receive a rating of lower than A may not bother with getting a rating at all.
Better returns for added risk: With the large companies with good credit ratings, you don’t need to be very cautious. They are very likely to repay their debt, but this is why they’ll only offer a miserably 0.1%-0.2% higher than the best bank FD rates. You could even argue that the whole point of taking the trouble to invest in a company FD is lost. On the other hand, companies that do offer high returns could come with a lot of risk. This risk may even apply to your principal. For example, a few days after Gitanjali Gems launched its company FDs (in early July 2013), which promised a yield of 12.5% over three years, the company’s share price has dropped severely. This has brought into question its ability to repay its debt.
Read up, but it won’t be foolproof: Lay investors tend not to investigate a company before investing in it, but this is essential. While you may not need to be suspicious of a highly rated company, the smaller companies need to be vetted. You could do this by examining what’s being said about the launch of the scheme itself online. Make sure you know what kind of company you’re investing in and the fundamentals of the industry. You could also check out its track record over the past few years. The only problem is that even though the information is rosy, you could still end up in trouble. Gitanjali Gems, whose ability to service the debt is under question, has paid handsome dividends consistently over the past eight years.
Shorter terms are safer: If you believe you can handle the added risk from low- or unrated companies, consider stick to one-year deposits. The longer you stay invested, the greater your exposure to a bad business cycle. Do remember that low-rated companies usually launch company FDs when they are less likely to raise funds cheaply from any other source. However, companies reward higher tenures with better interest rates. JP Associates (unrated), for example, is offering 12% for three years and 11.25% for six months.
Withdrawals are costly: Many banks are now fine if you withdraw your FD prematurely. No penalty is charged. Companies have higher penalties, though, with some offering even no liquidity. This is true for even the larger companies. For example, with Dewan Housing Finance, you will get 3% less than the promised rate in some cases. Gitanjali Gems has said that it will not accept any pre-mature withdrawals in the first six months, while approval for any such application after this time will be solely at the company’s discretion.
|Company||Rating||One year||Two years||Three years|
|HDFC LIMITED||FAAAA (CRISIL)||8.90%||9.05%||9.15%|
|SHRIRAM TRANSPORT FINANCE||TAA (Fitch)||9.25%||9.75%||10.75%|
|Mahindra and Mahindra Financial||FAAA (CRISIL)||9.25%||10.00%||10.25%|
|DHFL LTD||AA+ (CARE)||10.50%||10.50%||10.50%|
*all rates as on August 9, 2013