The 14% Unrated NCD
Ramesh, 55, owns a small packaging business and has Rs 1.2 crore of surplus cash after selling a property. His daughter begins a two-year postgraduate programme abroad in 30 months, and he wants the fees (about Rs 45 lakh, in foreign currency) parked in something that pays a fixed 13-14% so that the money grows to cover the cost. His banker has offered secured non-convertible debentures of a real estate developer: 14.25% coupon, three-year tenure, unrated, privately placed, minimum application Rs 10 lakh, proposed to be listed on a small exchange. The company's latest two quarters show interest coverage of about 1.1 times, debt of roughly Rs 340 crore against annual revenue of about Rs 95 crore, and its auditor has flagged a going-concern note. Ramesh wants to commit 60% of the surplus and says, 'It is mortgage-backed, so my capital is safe, and in any case the coupon is fixed.'
1. Evaluate the client's two beliefs: that the mortgage makes the capital safe, and that a fixed coupon means a fixed return.
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Both beliefs are wrong in the way that matters.
Security is not the same as liquidity or certainty of recovery. A mortgage over property only helps after a default, and enforcement in India typically takes years of proceedings. By then the property may be encumbered by senior lenders, statutory dues and other charge-holders; the debenture holder may rank below secured bank facilities. Recoveries in real-estate insolvency have historically been well below 100% and slow. For a goal with a date, 'recoverable eventually' is not the same as 'available in 30 months'.
The coupon is fixed; the return is not. The return to the investor is coupon minus defaults minus reinvestment risk minus liquidity. A 14.25% coupon against a government security of similar tenor is a market statement that a substantial probability of non-payment is priced in. Interest coverage of 1.1 times means operating profit barely covers interest, before principal repayment; debt of Rs 340 crore against Rs 95 crore of revenue, plus a going-concern note, points to refinancing risk. An unrated instrument has no independent credit assessment at all, so the client is relying entirely on the issuer's own marketing.
Finally, the client's liability is in foreign currency. Even a perfect rupee return does not immunise the education cost against rupee depreciation of 3-5% a year.
2. Apply a suitability framework: what should the adviser recommend for the Rs 45 lakh education goal, and what is the maximum defensible exposure to this instrument, if any?
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Work goal-first, not product-first.
Step 1 - classify the goal. The education payment is a fixed-date, fixed-currency, non-negotiable liability in 30 months. Money needed in 30 months cannot be exposed to credit default, illiquidity or currency swings. It belongs in a ladder of bank FDs, a liquid or short-duration debt fund of high credit quality, and possibly a short-term bond ladder - and partly in a foreign-currency or global fund if the adviser is equipped to manage that.
Step 2 - stress the instrument. Interest coverage of 1.1 times and a going-concern note means this is equity-like risk with a debt wrapper. It is unsuitable for the goal. For a client whose risk profile tolerates high risk, a small satellite allocation from surplus that is not earmarked for any goal may be defensible - commonly no more than 5% of the investible surplus per issuer and under 10% across such instruments - and never from goal money.
Step 3 - quantify. Rs 45 lakh earmarked for fees: exposure should be nil, or a token amount the client can lose entirely without affecting the goal. The remaining Rs 75 lakh is goal-free surplus; a 5% slice, about Rs 3.75 lakh, is the outer limit for a client who insists, subject to it being above the Rs 10 lakh minimum - which itself tells you the instrument is designed for wholesale investors.
Step 4 - document. Record the risk profiling, the recommendation, the reasons the instrument is unsuitable for the goal, and any written acknowledgement if the client overrides the advice. An adviser who recommends an unrated, illiquid, going-concern issuer for a two-year education goal is exposed to a suitability finding regardless of what the client signed.
3. The client insists and says he will sign anything. How should the adviser handle the override and what must be disclosed about the product and the adviser's own position?
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A signed waiver does not transfer the adviser's suitability obligation, but it does change how the conversation must be documented.
Do:
- Put the recommendation in writing with the specific reasons - interest coverage, going-concern note, unrated status, absence of a liquid market, mismatch with a 30-month goal, currency exposure.
- Cap the exposure to an amount he can afford to lose entirely, and separate it from the education money by placing it in a different folio or demat account with a note that it is not goal money.
- Confirm the instrument's actual terms in writing: privately placed, unrated, listing on a small exchange does not equal liquidity, and there may be no buyers at all before maturity.
- Disclose the adviser's own position: any commission, placement fee, referral fee or relationship with the issuer or arranger. If there is any such payment, the conflict must be disclosed before the transaction, not after.
- Explain the tax treatment of interest (taxed at slab) so the post-tax comparison with an FD is fair.
- Record that the client was told the instrument is unsuitable for the stated goal and chose to proceed.
The adviser should also be clear about what he will not do: he will not describe the product as 'safe', will not project the coupon as a return, and will not sign any document that characterises the advice as suitable. If the client wants the entire Rs 1.2 crore in it, the professional answer is to decline the mandate rather than participate.