Corporate FDs: Why the lure of higher interest mustn't make you overlook the risks

 Corporate FDs: Why the lure of higher interest mustn't make you overlook the risks

 

  

Morepen Laboratories’ fixed deposit holder might finally see a closure. Not all corporate fixed deposits end in a mess, but choose your FD with care

 

Just imagine the plight of an investor who invested in a fixed deposit (FD) with a maturity of three years, but ended up waiting for two decades to receive the maturity proceeds. Depositors who had invested in the corporate FD of Morepen Laboratories in March 2001 (which was due to mature in January 2004) are still struggling to get their money back. The company started defaulting on payment of interest and maturity amount to investors in 2002. Agitated investors went to court and offered some form of settlement; in 2009, the company allotted equity shares in lieu of FDs to investors.

Last month, Morepen reached out to these shareholders (originally FD holders) and has agreed to repay the FD amount, in line with last year’s order of the National Company Law Tribunal (NCLT). The company asked investors to surrender the equity shares in return. The firm asked its FD investors to fill up a form, provide proof that they still hold Morepen shares and mail them the details by August 31. Despite the massive delay, investors still had to complete the paperwork to get back their dues. How long it would finally take for the amounts to be fully repaid is still unclear.

Not the first or the last case

Morepen is not an isolated case. There are many more horrifying stories of gullible investors being taken for a ride with promises of higher returns.

Of course, there is nothing wrong in looking for higher returns. As a result of the recent fall in interest rates offered by bank and post office FDs, and small savings schemes, many people are looking for alternatives that can provide a little higher fixed return. Sensing the opportunity, many companies are offering FDs with assured returns, which are generally 1-3 percentage points higher than the rates given by banks for similar periods.

While corporate FDs offer higher returns, they also carry additional risks and, therefore, you need to tread with caution while putting your hard-earned money into such schemes. Here are a few dos and don’ts corporate FD depositors.

Evaluate the risk

Risk and reward have a positive correlation—where returns are higher, the risk tends to be higher too. Low risks mean that the interest rate on offer would be lower. “Any additional return that you may get in a corporate FD as compared to bank deposits should be evaluated keeping in mind the additional risks that you are taking,” says Lovaii Navlakhi, managing director and chief executive officer, International Money Matters.

Take a minute to understand why companies would offer higher returns. Varun Girilal, executive director, Mitraz Financial services Pvt. Ltd, a financial planning firm, says, “Investors need to be aware that if they are getting a higher interest, it is not because of a special deal or opportunity. In most cases, it is because the risk is higher and one can stand to even lose capital for a few two to three percent point higher returns.” Ideally, check what a comparable tenure’s bank FD rate is vis-à-vis the corporate FD’s interest. A wide difference is a red flag.

Don’t go overboard

Let's say you are comfortable with taking higher risk. Even then, you must limit your exposure to corporate FDs. “If one has decided to take the risk of investing in corporate FDs, I would suggest not to take the investment beyond 10-15 per cent of the portfolio in the corporate FD,” says Girilal. Further, one should not allocate more than 6-8 per cent in a single company, adds Girilal. Preferably, avoid a portfolio of corporate FDs; at best, stick to one or two such companies.

Bank FDs are covered by the Deposit Insurance and Credit Guarantee Corporation for up to Rs 5 lakh. This is not the case with company FDs. Therefore, advises Navlakhi, “limit the quantum to what you can afford to lose."

Invest in high-rated deposits

While selecting a corporate FD for investment, check the credit ratings. Typically, a company FD that offers a higher return has a lower credit rating. Consider only those corporate FDs that have a rating of AA or higher. The FDs that have AA or higher rating tend to give lower interest rates than those that are not rated or have lower ratings. But the chances of default (interest payment and return of funds) are much lower in corporate FDs with high ratings. Also, to ascertain the quality of the corporate FD, if possible, explore the underlying asset against which it is raising funds. Try and get a sense of the financial health of the company and the sector. For instance, in the present times, avoid investing in companies that are in stressed sectors such as real estate, infrastructure, textiles and aviation.

Besides that, check the past repayment track record of the company. Keep an eye out for any overtly negative news about the company in the media; those are the typical red flags.

Invest for a shorter period

Choose your tenure with care. Ideally, you should not invest in an FD for a long tenure. “Risk will increase in this asset class if the tenure is increased. Hence, we would recommend deposits for tenures of one to a maximum two years,” says Navalakhi.

“The longer the tenure, the more the chances of uncertainties,” says Girilal. He too suggests that one should keep the tenure of corporate FDs to 1-2 years.

Further, financial planners are of the view that instead of corporate FD, one could consider investment in mutual funds (MFs) as these are well regulated, and the safety quotient is much higher than corporate FDs. Plus, in the long run, MFs can provide better tax-efficient returns.