Why I applied for Muthoot Finance's NCD yielding 8.6% per year

Muthoot Finance, which is a gold-lending institution, is launching an IPO of its non-convertible debenture (NCD) which is yielding as high as 8.6% per year.

An NCD, for those who may not know, is a "fixed income instrument" that is similar to a bond or a bank FD.

NCDs do, however, differ from a bond or a bank FD in that they are riskier on account of their lower hierarchy in the case of default by a company. Owing to their increased risk, they also offer higher returns compared to a bond or a bank FD.

So when exploring NCDs as an investment option, it is utmost important that we ensure the company has sound fundamentals.

CREDIT RATING

One of the many criteria to look at is the credit rating of the NCD. As a matter of rule, I only prefer NCDs that are rated AA+ or above. While credit ratings are far from being fool-proof (there have been many instances where even companies with AAA credit ratings have defaulted), they do provide a basic filter to an investor.

Besides credit ratings, I also look at the company's fundamentals, including past corporate governance.

So as for Muthoot, we know that the company lends funds to borrowers by taking gold as collateral from them. Lending against gold provides a cushion to the company if the borrowers fail to repay. To recover the loan, Muthoot can always auction the gold jewellery in the market.

LOAN TO VALUE RATIO

Also, as per RBI's guidelines gold-lenders are only allowed to lend an amount of up to 75% of the total value of gold (excluding studded gems or diamonds) held as collateral from the borrower. But Muthoot lends only about 65% of the value of gold collateral -- which is quite safe. So even if the gold prices fall, Muthoot would be cushioned against losses in case of borrower default.

To be sure, a fall in gold price does impact the total loan growth of Muthoot, since loans are provided as a % of the gold collateral taken from the borrower.

But the converse is also true. If the price of gold rises, then Muthoot has extra buffer since the value of the gold collateral kept in its safe rooms also rises.

HIGH CAPITAL ADEQUACY

The relative safety of capital that Muthoot enjoys by virtue of keeping gold as collateral is reflected in the company's high capital adequacy ratio (CAR) of 33%.

What is a CAR ratio? In simple terms, a CAR ratio indicates whether and how well a bank or any lending institution is able to weather the downturns in its business. In other words, it tells us how much capital does the bank have to absorb any losses arising out of defaults of its customers.

In Muthoot's case it has 33% of its assets (which are essentially loans given out) as capital. In other words, it has enough capital buffer to protect against losses.

HOW MUCH DOES MUTHOOT EARN?

You may also want to look at what interest rate Muthoot pays on its own borrowings (loans taken from banks or funds borrowed from the market through NCDs) versus how much it earns on gold loans given out.