Investing in Corporate Fixed Deposits
Not happy with the interest on bank fixed deposits? You’d prefer to invest in a fixed deposit with a company and earn the incremental 2-3% return. It must be noted that any financial instrument that has a higher expected return also comes with higher risks. It is important to understand all these risks and make sure they fit your profile before making the investment. In this article we will run you some of the important things to be taken care of before you lend your hard-earned money to a company.
What is a Corporate Fixed Deposit?
Corporate deposits work exactly like bank fixed deposits. The difference being that the bank deposits are issued by banks, whereas the corporate deposits are issued by companies – both public and private. You would lend money to the company for a decided tenure at a fixed rate of interest. The interest may be payable quarterly, semi-annually or annually (non-cumulative) or along with the principal amount at maturity (cumulative).
Understanding the Risks in a Corporate Fixed Deposit
One must understand that in case of bankruptcy of a company there is a hierarchy by which the creditors get paid the residual amount. The government dues, such as any taxes & fees are paid first. Of the leftover, secured loans (loans received against a collateral) are paid next. After this, unsecured loans are paid if there are any funds left.
Since corporate fixed deposits are unsecured in nature, they carry a higher interest rate. In other words, if the borrowing company is to default, you as a lender do not have any asset from the borrower which you can sell to make up your loss. It is because of this extra risk that they offer a higher interest rate.
There have been various instances in the last couple of years where companies have gone into a financial tailspin. Their financial health has deteriorated to a level, where they have not been able to repay the investors on maturity. One such case, where the investors could presumably lose a lot of money is Dewan Housing Finance Ltd. (DHFL).
Credit: LiveMint.com - spelling out the plight of retail FD investors
What’s worse is that the maximum investors in such FDs are individuals who need a regular fixed income, such as retired individuals. These are people who cannot afford to invest in riskier asset classes such as equity as their risk appetite is low.
One must also note that corporate fixed deposits are not regulated by RBI regulations. Instead these corporate deposits are governed by provisions 73 to 76A of the Companies Act, 2013. Which means they are not covered by the Deposit Insurance and Credit Guarantee Corporation (DICGC), which guarantees up to Rs. 1 lakh (Rs. 5 lakhs from FY 2020-21) on deposits with banks.
Pre-Closure of Deposit
Most corporate fixed deposits do not permit pre-mature closure before 6 months. Even if they do allow this, normally the penalties involved are very high. Not only the penalties, the paperwork involved is tedious and cumbersome. On the other hand, in case of bank deposits, though there are penalties involved, they are generally lower, and the procedure is much simpler.
What to Watch
Even though the credit rating agencies have not done a great job in the previous few years, with AAA rated companies going into default, credit rating is always a good starting point. One could filter out any low rated companies.
Track Record of Company
It is always a good idea to study the company’s business and operations. One must make the effort to do some research regarding the fundamentals of the company and particularly check the debt levels that the company has. If the company has too much loan on its books, and most of its earnings is going to payment of interest, it should be a negative signal for the investor.
Diversify your funds
As the age old saying goes – ‘Never put all your eggs in one basket’. Even if an investor does decide to invest in the fixed deposit of a company, one must be careful not too commit too big a fund into the company. God forbidding, even if the company is to default, your other investments can always bail you out.
Tax Deduction at Source
The company would deduct a 10% TDS on interests over Rs. 5,000 in a financial year. In case the investor falls in the nil or zero tax bracket, he must submit a duly completed Form 15H in duplicate every financial year to avoid TDS deduction.
Study the Application Form
The application form for a corporate fixed deposit generally contains fine prints regarding rules, such as penalties and permission for pre-mature withdrawal. Also, the company’s financials such as profits for the previous 3 years are printed on the application form.
At the time of applying for a fixed deposit an investor must fill in the nominee details. In case of the unfortunate death of the applicant, it makes the process much easier for the nominee to claim the withdrawal receipts.
All-in-all, corporate fixed deposits are a good product to be able to get a better return than a bank fixed deposit. However, while investing one must take care of the points mentioned above. Corporate fixed deposits in stable companies is a good option for investors who have a low risk appetite and cannot bear or afford the volatility of an asset class like equity.