An Analysis of the Issue

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The ongoing correction in equity markets offers a good case for diversifying investments into fixed income instruments such as corporate non-convertible debentures (popularly called “NCDs”).

What are these?

Simply put, NCDs are instruments through which investors give loans to a company in need of funds. In return, the company promises to provide a fixed return (currently 8% to 9%) per year and repayment of the entire principal at maturity.

Companies routinely need funds either for operations, or capital expenditure, or repayment of interest or principal on existing loans. To arrange funds, they typically have three options:

One, they can utilise internally generated funds (IGF) or reserves, which are funds drawn from the accumulated profit of yesteryears. Of course, if the company has been losing money every year, then it may not have access to IGFs. Two, in that case, it can issue new stock (also called equity), which gives equity holders ownership rights to the company. Third, it can also seek loans (called debt) from either banks, institutional investors, or general public. 

The NCDs fall into the third kind. If a company decides to raise debt instead of using IGFs or issuing equity, then it may issue NCDs in the market. Retail investors like you and me, high net worth individuals, or institutional investors can subscribe to these instruments and, in effect, give loans to the company. In return, the company promises to provide a fixed return at periodic, pre-decided intervals.

TATA CAPITAL FINANCIAL SERVICES TRANCHE II NCD ISSUE

TCFSL is a systematically important, non-deposit taking, non-banking financial company (NBFC). According to its prospectus (pg. 76), the company intends to use the proceeds received from NCD issue for the purpose of “onward lending, financing, and for repayment /prepayment of interest and principal of existing borrowings and for general corporate purposes.”

The gross size of the issue is Rs 4126 crores, and the base size is Rs 500 crores. Out of total Rs 4126 crores, NCDs worth Rs 2997 crores are secured (meaning backed by certain assets), and the rest are unsecured. The issue opens on 13th August 2019 (coming Tuesday) and ends on 23rd August 2019. The coupon (interest) rates range from 8.45% to 8.85% depending on the maturity chosen (3, 5, 8, or 10 years) and investors type (retail, HNIs, or institutional). 

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ANALYSIS OF THE ISSUE

Credit Ratings: When evaluating an NCD issue, the first thing one should consider, besides the company’s managerial and financial standing of course, is its credit rating. A credit rating is the barometer, albeit a loose one, of a company’s ability to service the debt. As a thumb rule, I stay away from AA or below rated NCDs. 

This is not to say that higher-rated issues are necessarily safe. As we witnessed in the ongoing NBFC crisis lately, even AAA rated issues defaulted within months of them being rated as such — mainly owing to the collusion of rating agencies with the company management, poor corporate governance standards of the company, or lack of strict due diligence on the part of the credit rating agency. 

So while one should be extra-cautious while relying on credit ratings, these ratings do provide a rough idea about the NCD issue’s credit (default) risks involved. TCFSL is rated AAA (Stable) by both CRISIL and CARE, which is good. 

After evaluating the credit ratings, one should study the prospectus in detail. In Tata Capital’s case, the prospectus for Tranche 2 can be found here. It is a 530 page long document, but who said investing was easy? The prospectus gives vital information about the company such as how will the proceeds of NCD be utilised, the current outstanding liabilities, interest rates on outstanding loans, recent financials, and so forth. You could also go through the annual report to evaluate the financial & business situation of the company.

TCFSL is a high growth NBFC, which could be seen as positive or negative. Its gross income in financial year 2018-19, for instance, grew by 29% over the previous year to Rs 5586 cr. This was on back of high loan growth of about 21% to Rs 44623 crore. On the positive side, this could mean higher interest income from these loans in future as well. 

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But on the flip side and in the long term, such growth could result in higher bad loans if the borrowers lack quality. In the short term, it could also artificially default the non-performing asset ratio. The company’s Gross NPA as of 31st March 2019 was 2.45%, which is decent. But given that the NPA figure is shown as a proportion of total loans, the high growth in loans (denominator) could be deflating the real magnitude of NPAs. The net NPA, which accounts for provisions, is 0.39%.

Capital Adequacy: The company capital adequacy ratio (CRAR) is also at a comfortable 16.84 %, higher than the 15% minimum prescribed by the RBI for systemically important NBFCs. Its Tier 1 capital ratio is 12.11%. One risk is a potential rise in NPAs could threaten the CRAR. Given that this is a high growth company, the status of NPAs needs to be monitored consistently.

Composition of Loans: In terms of their customer base, the company’s commercial finance division accounts for a major (58% approx) chunk of income.The remaining is accounted for by the retail, that is consumer finance and advisory, division. 

Within commercial finance, about 35% comprises supply chain finance and 27% comprises term loans. It is important to note that the company has steadily reduced its dependence on construction equipment finance to 16%of the total commercial loans. Construction equipment finance made up for a substantial portion, almost half or 50%, of loan book about 10 years ago. 

This shift in the loan book composition is welcome since equipment finance business is heavily dependent on the real estate sector, any slowdown in which could threaten the revenues of the company. But the higher concentration of commercial loans at 58% in general is a little risky given the ongoing slowdown in private investment and consumption across the economy. 

Net Interest Income & Expenses: As of 31st March 2019, the company seems to have interest income (interest income divided by financial assets) of 11%. Its interest expense (finance cost divided by financial liabilities) is about 7%. This translates to a spread of 4%. If we deduct operating expenses such as salaries, electricity, and so forth which comprise about 2% of the liabilities, even then there is a residual spread of 2%, which allows leeway to pay for the current NCD issue. 

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Liabilities: The company as of FY19 had total financial liabilities of Rs 41851 crore. This includes public and privately placed NCDs of Rs 16090 cr (38.44% of total financial liabilities), and the rest in term loans, working capital loans, bank overdrafts, and commercial papers. The average interest rate that the company is paying on these liabilities seem to be about 8.7% as per my rough calculations, and so the current NCD issue at a coupon of 8.45-8.85% seems to be decently priced. 

To me, the financial & business position of the company seems stable at this juncture.

However, should you decide to subscribe to the NCD issue, which opens on 13th August 2019, you must keep in mind the risks involved. For one, the credit risk or the risk of the company defaulting on its payments in case of financial difficulties. 

The company also faces interest rate risk, which is the risk to the company’s income in case of a change in interest rate. In the present scenario of decreasing interest rate, for instance, the customers may find it attractive to repay loans early. One way they can do this is by refinancing the high interest rate loan at the prevailing lower rate. 

This exposes the company to prepayment risk. In the low interest rate environment, the company may be forced to give loans at lower rates, especially in a competitive environment. This could threaten its net interest income. 

There is also liquidity risk, which is the risk of not being able to sell the NCDs in the market, on NSE or BSE, owing to lower liquidity.

Disclaimer: I am not a SEBI registered advisor. Please consult your financial advisor before taking any investment action.





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Harsh Vora
Harsh Vora is a proprietary investor & day trader with more than 10 years of experience in financial markets. He is a finance graduate from the Marriott School of Management, BYU and a public policy graduate from The Takshashila Institution, Bangalore, where he won the best academic performance award. Occasionally, he teaches economics to its students.
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