Should you invest in NCDs
Conservative investors are always in search for that elusive 1% return. And they are ready to put on the dancing shoes if they can pocket double-digit returns with safety of capital and timely payment of interest.

That is why many are now looking at the non-convertible debentures (NCDs) of gold loan financing companies with great interest.

Look at these numbers: Yield to maturity on NCDs of Muthoot Finance, Manappuram Finance and IISL are in the range of 14% to 16%, while yields on bonds of state-run NHAI, REC and PFC are in the range of 8% to 8.5%. That is 5-6% higher - something many debt investors would be reluctant to let go. NCDs of L&T Finance - N5, trading at 976 and maturing in 11 months from now in March 2013, giving a yield to maturity of 12.38%. Those with a time-frame of 2 years, could look at Dr Reddy's - N1 option, which gives an yield to maturity of 12.09%.

Gold loan financing companies are risky
However, investors would still proceed warily as most of them are worried about the safety of their investments. After all, a PSU bond comes with the government backing, while gold loan financing companies are risky.
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"Public sector undertakings are backed by the Government of India and many of them like NHAI, PFC have AAA rating. On the other hand, gold loan companies have a lower rating and have a single product. Also, the Reserve Bank of India has tightened the lending norms for these companies. That is why there is a huge difference in returns between these two sets of companies.

Interest income from PSU bonds like NHAI, REC and PFC is tax free in the hands of investors. As compared to this, income from gold loan companies is taxable.

How to proceed
Since you have taken your eyes off those eye-popping yields, consider these factors carefully. To begin with, consider the tax implications of your investments in these bonds. For example, the 10-year bonds of NHAI - N1. These bonds pay you a coupon of 8.2% which is tax free and are available at 1,020, thereby giving you a yield of 8.11%.

On the other hand, you have Muthoot Finance - N6, with a face value of 1,000 and a coupon of 12.25% trading at 966, giving you an yield to maturity of 15.58%. But the trouble is that the interest income from Muthoot Finance - N6 is taxable. So, if you are in the highest tax bracket (tax rate of 30.6%), your yield will be only 10.81%. Sure, it is still almost 3% more than the PSU bonds.

With that we come to another important aspect of debt investing: Risk. PSU bonds like those of NHAI, PFC enjoy AAA rating, while Muthoot Finance enjoys a Crisil AA- rating. Manappuram Finance has a CARE AA- rating.

"Most gold loan companies are single product companies and carry a higher risk due to their lower rating than PSUs. Only those with appetite for risk should buy these bonds, and such bonds should not constitute more than 10% of your portfolio.

Timing it right
Another potential trouble is the longer tenure of the PSU bonds. For example, NHAI, REC and PFC come with tenures of 10 to 15 years. If you have a time-frame of two to three years, it is better to avoid 10- or 15-year bonds.

This is because if interest rates move up, the bond prices will drop and you may suffer a capital loss. "Buy with an objective of holding to maturity, else there is a chance of a capital loss.

Investors with not much time in hand can look at other alternatives such as NCDs of L&T Finance - N5, trading at 976 and maturing in 11 months from now in March 2013, giving a yield to maturity of 12.38%. Those with a time-frame of 2 years, could look at Dr Reddy's - N1 option, which gives an yield to maturity of 12.09%.

Longer tenure bonds will benefit?
However, the longer tenure bonds will benefit the most when there is a drop in interest rates. The Reserve Bank of India has already cut the cash reserve ratio (CRR) - cash to be maintained by banks - by 1.25% since the beginning of 2012 and there are expectations that the central bank will cut repo rates by 25-50 basis points in the coming months.

If repo rates are cut, bond prices will move up and PSU bonds with a longer tenure will benefit the most.
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