IndianMoney.com Research Team | Updated On Thursday, October 17,2013, 03:21 PM
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Among the many investment avenues present in India a corporate fixed deposit is one of the least understood. Many people in India have burnt their fingers investing in this financial instrument due to the lack of understanding on how it works. This has led to a fear among investors that these financial instruments are dangerous and best left alone. Perhaps it is time to understand more about a corporate fixed deposit.
What is a Corporate Fixed Deposit?
Banks are the biggest issuers of fixed deposits in India. In addition to banks Companies also offer fixed deposits. These are known as corporate fixed deposits. When Companies need to raise cash in a hurry they offer deposits at attractive rates of interest. Many Companies offer interest rates higher than bank fixed deposits. Investors are issued deposit certificates of different tenures at fixed interest rates.
Why do Companies Offer Deposits at a Higher Rate Than Bank Fixed Deposits?
Bank deposits are secured by the RBI up to a Lakh which means each depositor will get this sum if a bank goes bankrupt or does not pay back ones money. No such guarantee is offered on a Company deposit. This translates to an unsecured deposit. which bears a default or a credit risk. The Company might suffer heavy losses in business and be out of funds. The Company might default on the interest payments and might not return the matured amount. In this case the investor stands to lose the principal amount invested. This makes the corporate deposit a very risky investment .In order to compensate this risk the corporate deposit gives a higher rate of interest than a fixed deposit .Higher the credit risk greater are the interest rates offered. This translates to a return comparable to an inflation adjusted rate of return which is better than a bank fixed deposit albeit at higher risk.
In order to aid investors in assessing the risk involved and help investors make sound investment decisions CRISIL a rating agency helps grade corporate fixed deposits.
FAAA : This is the highest safety grade rating for a Company and means that the chances of a Company making timely interest payments and returning the principal amounts are very high. An investment in this type of a Company will carry low risk.
FAA+ : This means that the degree of safety regarding interest payments and returning of matured sums is strong but not as high as the earlier case. Investment in this type of a Company carries a lesser risk.
FAA : This means that the degree of safety regarding interest payments and returning of matured sums is strong Investment in this type of a Company carries a lesser risk.
FA : This means that the degree of safety regarding interest payments and returning of matured sums is satisfactory. Changes in the macroeconomic environment have a bearing on these kinds of Companies as compared to higher rated Companies.
FB : This means that the degree of safety regarding interest payments and returning of matured sums is inadequate. These have a higher safety margin than the lesser rated Companies. However changes in the macro environment do have a bearing on such type of Companies.
FC : This means that the degree of safety regarding interest payments and returning of matured sums is doubtful. These kinds of Companies carry a high default risk. Drastic changes in the business and macroeconomic environment could force these Companies into a willful default or a forced default which leads to investors losing on interest and maturity sums.
FD : This means that the Companies are in default or expected to default and cause loss of interest and maturity sums to investors.
NM : Companies facing reorganization or liquidation and the obligation being in dispute in a court of law renders a "not meaningful" rating.
What are the Interest Rates Offered on a Corporate Fixed Deposit?
Companies which have a high rating offer interest rates on different tenures of corporate fixed deposits of 1-5 Year tenure. The interest rates varies from 9.25% - 10.75% depending on the tenure. Companies with a lower rating offer a higher rate of interest than the highly rated ones to make up for the default risk. Companies which offer interest close to 15% per annum should be avoided. Many new Companies and those with an uncertain future regarding future policy offer interest higher than 12%.These need to be viewed with caution .Companies do not need to be mandatorily rated .Even if they do; disclosure of the rating is up to the Company. However Companies with good ratings can easily obtain deposits from the public.
What are the Taxation Aspects of a Corporate Fixed Deposit?
Corporate fixed deposits have tax deducted if the annual interest exceeds INR 5000.There is no capital gains tax on these deposits.
What are the Factors to Be Noted When Investing in a Corporate Fixed Deposit?
One must be very cautious when investing in Companies offering interest as high as 12.5% a year. A Company offering very high returns in excess of 12.5% is not authorized to collect funds from the public by the RBI. Companies with very high risk of default and questionable finances offer very high rates of interest and then do not pay back the investors Many investors fall for these schemes resulting in a bad name for corporate fixed deposits. The RBI maintains a list of NBFC Companies which are allowed to collect deposits from the public .Investors should carefully go through the list and invest in only those Companies which are listed in the RBI website.
Investing in a corporate fixed deposit of a short tenure is the way to go rather than invest in deposits of a longer tenure. One does not know what the business cycle would be over a longer period of time and deposits of a shorter tenure are generally safer to invest.
One needs to check the financial health of the Company before opting for a deposit .All Companies raising deposits need to disclose the net profit and the dividend paid over the past three years. A thorough study of the Companies audited balance sheet as well as the profit and loss accounts needs to be made. The dividend payouts need to be checked. The Companies are obligated to mention any default in payments in the past to the retail investors. If a Company is raising funds for its subsidiaries also check their financial health.
One needs to note the terms and conditions in case of a premature withdrawal of a corporate fixed deposit. A bank fixed deposit can be withdrawn prematurely on the payment of a penal amount of around 2%.Some corporate fixed deposits do not allow premature withdrawal for a period of 3-6 Months. If premature withdrawal is made no interest accrues on the deposit. Certain Companies on a premature withdrawal between 6-12 Months deduct around 2-3% on the interest rate offered.
One should avoid deposits in Companies which one knows little of and relatively new Companies. Companies which find it difficult to raise capital in the markets and secure funding from banks look at this route as a measure to secure funds as the deposits are unsecure. That makes it extremely risky for retail investors. Another important factor to be noted is the amount of shares of the promoter of the Company pledged with a lender. If it is more than 50% it is a worrying sign. In case of financial ill health of the Company the share value would go down. This would result in a greater number of shares being pledged. If the promoter is unable to pledge more shares the lender will start selling the pledged shares. This results in the share value plunging. This is certainly bad news for its corporate fixed deposit and the investors.
In case of infrastructure Companies one must note that they can get stuck in environmental issues and not get the necessary regulatory clearances. This would affect the Company and its corporate fixed deposits.
I would like to end this article advising the investors that corporate fixed deposits may offer a higher interest rate than the bank fixed deposit but have their share of risk. They certainly come nowhere near the ease and comfort of a bank fixed deposit. A through research is necessary to invest in a corporate fixed deposit in order to gainfully profit from the higher interest rates offered.
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IndianMoney.com Research Team
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