Adventure in trading NCDs – Tata Capital NCD Arbitrage

A good friend of mine, and a reader of this blog complained recently that I write about where not to invest but hardly about where to invest (of course, he did not say it nicely – he interspersed it with shudh hindi gaalis). This is an attempt to rectify that, although must warn you that the returns hardly come up to any substantial number. I personally felt analyzing this situation very intellectually stimulating. The opportunity is still available (so that my good friend can invest 🙂 ) although the returns are nothing to be excited about. So, here goes.

NCD (Non-convertible debentures) are a very recent and interesting development in the bond markets in India. NCDs at a very basic level, allow companies/corporates to issue debt to the public and the market is growing for the past 2-3 years (Muthoot, Mannapuram, Shriram group, Tata group etc. have issued them). NCDs can be secured (as in, backed by assets) as well as unsecured.

Tata Capital was one of the first corporates to come out with a NCD issue way back in 2009 (it was a secured issue). Here’s the link to their prospectus (and here’s the link to Deepak’s post in 2009 where he scared the bee-jesus out of everyone, and rightly so!). They had 4 issues – N1 (paid interest monthly 11% p.a), N2 (paid interest quarterly 11.25% p.a), N3 (paid interest yearly 12% p.a) and N4 (paid cumulative interest 12% p.a). And a recent announcement triggered a special situation opportunity almost immediately in my mind. Here’s a more detailed prospectus of that recent announcement.

If you are not very link-savvy (like me), here’s the summary. Tata Capital had something called a Put/Call option when they issued NCDs. Put/Call essentially meant that investors could surrender their NCDs/company can call in the NCDs at par value (in this case Rs.1000/-) after 3 years from the date of issue. They issued these NCDs in 2009 and they had an option to exercise the put/call in 2012 (which is now). Why would any corporate give such an option? Well, it’s a play on interest rates. Back in 2009, they gave us 12% because you could hardly raise any money at that point in time. However, in 2012 (3 years from date of issue), when the put/call option became active, Tata Capital realized that the interest rates were heading down, they wanted to call the costly bonds back/continue them at a lower interest rate. So, they said, boss, either you give us our bonds back (and we will pay you back the par value of the bond) or you can continue them at the rates as stated below –

image

At this point, you are probably saying – Ok dude, great information. Can you get on with the special opportunity please?

I’d say yes and probably go on to tell you that you have a special opportunity both in the N3 (Annual interest) and N4 (cumulative interest) series. I will enumerate the analysis for N3 (N4 follows a similar track).

When I started this analysis (03rd Feb weekend), Tata Capital N3 series was quoting at Rs. 1093/- (it is currently at Rs. 1100/-). N3 series pays out interest (12%) on 01-Mar every year and so it is with the current year too. The interest record date is 14-Feb (i.e., you need to own the bond as on 13-Feb-2012 for getting the interest). A 12% interest rate works out to Rs. 120/-.

Bond markets in the case of interest payment, work exactly like stocks which give out dividends. The markets reduce the price of the bond by the interest paid out. As time goes on after interest payment, the interest for the subsequent year starts accumulating and the price of the bond rises.

In this case, the price of N3 series might correct by Rs. 120/-. If I buy at 1093, the price should have fallen to 1093-120 = Rs. 973/- after the interest record date (14-Feb-2012). However, since Tata Capital has already decided to exercise its put/call, the minimum value that would be paid out is Rs. 1000/-. If we read through the recent announcement in detail, it clearly states that an investor can tender his NCDs between March 23rd and April 5th and Tata Capital while redeeming the NCD would also be paying the interest for the period from March 5th till redemption (which should be within a period of 3 months from March 5th). That is, redemption amount would be Rs. 1000 (par value) + any accumulated interest (from 5th March to redemption).

This special opportunity arises only because Tata Capital wants to redeem the bonds (just playing for interest is pure speculation) (for those who want to hold on to these bonds at a lower interest rate – good for you, I have some analysis for you as well at the bottom of this post!). I will detail out the arbitrage using figures –

image

Fantastic. A risk-free return on 17.90% p.a (if you do analysis for N4 series, it is more or less the same). At this point, I thought awesome.

And then it hit me. Tax. We haven’t considered the tax impact in this calculation at all. I am very ‘delighted’ after all this analysis to announce that interest will be taxed at the marginal tax rate and short term capital gains will also be taxed at the marginal tax rate. I will ‘eagerly’ take a 30% marginal tax rate and incorporate it into these calculations –

image

Ta-da! ‘Absolutely phenomenal’ returns of 1.74% p.a after incorporating the tax impact. I might be better off investing in a savings bank account which gives me a mammoth 2.8% p.a. post tax.

And I don’t think the Income Tax act allows you to claim a short term loss (I invested 1096, I got back only 1016 and hence loss of Rs. 80/- type of argument). The price of the bond fell after payment of interest and hence will not qualify for a tax loss.

N4 is no better.

Lesson learnt: Finding arbitrage situations in bonds (and NCDs) is difficult. Even if you find it, the taxman will not allow you to exploit it for decent returns. 30% tax rate is absolutely killing. For people in the 20% tax bracket, the returns in this arbitrage would work out to 7.04% (post tax, which is decent). NHAI bonds would give you a post-tax rate of 7.97% though, at today’s rates.

For people who want to stay invested in Tata Capital NCD at reduced interest rates (@10.5%), the yield works out to –

image

Of course, pre-tax is 11.38% p.a. Post-tax returns, it works out to 6.52% (tee-hee ).

image

Disclosure: People actually had to tie me in chains to not invest in this 🙂 . I mean, I was beaming with pride to find this special situation and read up a ton of material and then, the tax situation hit me. Not invested. And I say that with a heavy heart. Rationality doesn’t allow me to. I remember Munger ‘The stock/bond doesn’t know you own it – so, keep a check on your ego’.

And general point/advice. If you are not using XIRR while valuing bonds, you are doing it wrong. And please include tax considerations while calculating your actual rate of return.

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  1. #1 by saurabh shankar on February 9, 2012 - 8:17 PM

    Hi,

    Nice Read, damn the tax :(.

    Reading your article i remember reading the book on LTCM (When Genius Failed), which tell how LTCM would find arbitrage opportunities such as above one having small spreads, but would use leverage to make super profits for them. Not to mention that most banks gave them loans at almost zero cost.

    cheers,

  2. #2 by Tony on February 9, 2012 - 9:30 PM

    Dear Kiran, .
    I like reading your blog and the wonderful insights you bring out to the surface with so much clarity. There is one more opportunity coming in the way of spin-off. Its Fortis Healthcare. Would be keenly looking forward to your analysis on the same.
    Tony

  3. #3 by Kiran on February 12, 2012 - 3:25 AM

    @Saurabh – One of my fav. books 🙂 Too bad Indian banks don’t lend at zero cost 😉 and yes, welcome to my blog.

    @Tony – Thanks. I did look at it very briefly and it smacked of a lack of corp. governance…will analyse it in detail. Too many things (bull mkt, open offers) happening that I haven’t been able to evaluate multiple spin-offs…Fortis, Provogue, NRB Bearings, Orient Paper etc. Will try to in a while. Welcome to my blog 🙂

  4. #4 by bemoneyaware on February 13, 2012 - 2:01 PM

    Great information and well presented though I haven’t invested in NCDs.

  5. #5 by A V Veerkar on February 14, 2012 - 10:58 PM

    Any view on tax ability of redemption amount? In case of N4 ( cumulative ) the gain on redemption is to be treated as capital gain or interest? The company will pay me back Rs1400 on redemption. Can I show the whole 400 as capital gain or I should have declared accrued interest every year?

    A V Veerkar

  6. #6 by Kiran on February 15, 2012 - 3:06 AM

    It depends how you bought and sold.

    400 rupees is interest if you had subscribed to Rs.1000 par bond and redeeming at Rs.1400 at the end of the term.

    If you have bought and sold on the exchange without any interest getting credited in your account, it will be treated as short/long term capital gain. Again, short term cap gain tax treated the same way as interest. Long term cap gain on bonds can be indexed if you like. 20% without indexation and 10% with.

    Hope that answered your query.

  7. #7 by A V Veerkar on February 15, 2012 - 6:25 AM

    Thanks Kiran. But let me elaborate. I buy N4 at 1000( either from primary or secondary market). First year my accrued int is say 120, second year 130 and third year 150. Company would pay me 1400 ( 1000 + 120+130+150 ) on redemption after 3 years. I thus declare interest for three years and pay tax accordingly. But now instead of waiting for redemption if I sell the debenture for 1400 just before redemption, then I have a LTCG of 400 on which I have to pay tax but then I had already declared interest for two years and paid tax. The LTCG of 400 rupees includes the accumulated interest on which I have paid tax in previous years and I will have to pay tax again on the same income now reflected as LTCG. This is a case of double taxation hence not valid. In my opinion since unlike fixed deposit, a cumulative debenture is a trade-able security whose price is quoted every day and since the quoted price actually includes the accumulated interest, any transaction in cumulative debenture should only be taken as LTCG ( or STCG as the case may be). Accrued interest should not be declared separately as Income from Other Source to avoid double taxation. Since technically there is no difference between selling the debenture just before redemption and getting money from the buyer and redemption and getting money from the company, I would feel that even on redemption Rs 400 gain could be declared as capital gain. I was told that in case of “zero interest bonds” which are functionally identical to ” cumulative bonds” i.e. you pay 1000 now and get 1400 after three years, Rs. 400 gain which is paid as premium to you is treated as LTCG. If so then same logic applies to cumulative debentures.

  8. #8 by Kiran on February 15, 2012 - 1:58 PM

    Tax needs to be paid only on realisation of money. That is, even if the interest is accrued, but not paid, we need not pay any interest.

    Other than that, I agree with you. If you sell it on the exchange, it will be LTCG. If they redeem it, seems like Interest income (since the redeeming amount was already defined). But if you have already confirmed on the tax liability for zero coupon bonds being LTCG, then my logic is wrong. It should be LTCG for cumulative bonds too then.

    Thanks for this. Very interesting and stimulating discussion.

  9. #9 by Ankur Jain on February 16, 2012 - 7:22 PM

    Hi Kiran,

    Few observations :

    1. Record date for payment of interest on N3 was Feb 15, not Feb 14.
    2. If the debenture holder doesn’t agree to the reduced rate of interest and wishes to redeem his NCD, should he not be given the same contracted rate of interest as earlier ? After all the company is taking extra time to redeem the NCD beyond the contracted date of March 5. The investor has already indicated his intention to not continue with the reduced rate and hence beyond March 05 till the time of redemption, the bond holder should be paid interest at 12% and not 10.5%. I have written to the company and awaiting a response from them on this issue.

  10. #10 by A V Veerkar on February 16, 2012 - 11:06 PM

    One more observation. Since in your example you had shown the purchase price as 1096 and you receive only 1000 on redemption, you are entitled to show a loss of Rs 96 on LTCG. This may not offset the tax you are paying on interest but will enable you to reduce your LTGC tax if you are paying any ( you are also allowed to carry forward your LTGC losses for next seven years if you have no LTGC gains to set it off against ).

  11. #11 by Kiran on February 19, 2012 - 4:02 AM

    @Ankur – 1. My bad. Interest record date was 15-Feb indeed.
    2. I agree. I had my misgivings about the 10.5% too. I am actually surprised that there has been no annoucement forthcoming from Tata Capital regarding its meeting on 15-Feb. So did the creditors finally agree to the revised interest rate? Will the bondholder who redeems be given a 12% rate instead of 10.5%? Do let me know if you get a response from them.

    @Veerkar – Are you saying that I can set off this STC loss against any other debt STC/LTC trading gain (equity LTC is not taxed currently, so we can rest easy)? Interesting. I might have to read up on the basic laws of taxation again. Do elaborate with an example please, if you don’t mind.

  12. #12 by A V Veerkar on February 19, 2012 - 9:39 PM

    Dear Kiran,

    It is true that STC losses can be set off against any STC gains in the same year and, what is more, any balance losses after this set off can then be set off against LTC gains in the same year. However not STC losses but LTC losses can be carried forward to next years.

    However in case of debentures under discussion ( N3 and N4 ) the applicable tax is quite different. Take N4 ( cumulative or deep discount bonds ) . On every 31st March you need to find out the value of the debenture and the difference between the current valuation and previous valuation ( in case you are holding the debenture for more than one year) or your procurement price ( i.e. you got the debentures allotted or you purchased them less than a year before ) is to be declared as Interest and you need to pay tax accordingly. If you decide to sell the debenture, the capital gain is the difference between your last valuation on 31st March ( and not your original purchase price ) and your selling price. This ensures that you do not end up with double taxation on income as interest and again as capital gain. Also note that since you take last valuation as your purchase price for calculating capital gain and not the original price, the gain is always short term and never LTCG. If you wait till redemption then the difference between the redemption and your last valuation or procurement price, whichever is later, is to be treated as interest. Thus if you buy N4 in Feb for 1380 and you are redeemed 1400 on 5th March then only Rs 20 is your interest income and there is no CG. Too complicated ? Well if you are a small investor ( face value of debenture holdings < 1 lac ) if you choose you can declare the whole amount as interest on redemption!!

    In case of N3 though you receive 120 as interest from the company you need to declare only 120-96 =24( if your purchase price is 1096 as you have mentioned ) as interest and your tax liability is 7.20 rupees.

    In case of zero interest or zero coupon bonds ( though they by nature are same as deep discount bonds or cumulative bonds ) you don't need to declare accrued interest every year. The whole redemption premium can be taken as LTCG. However these bonds are special in the sense that they are either issued by PSUs or by Infrastructure companies where capital is deployed strictly for infra development and these bonds are declared as qualified in the gazette. The differential treatment to zero interest bonds was given from Fin act 2005. However though treated as LTCG there is no indexation available.

    You may want to read about this at
    http://law.incometaxindia.gov.in/DitTaxmann/IncomeTaxActs/2009ITAct/sec_028.htm

  13. #13 by Kiran on February 20, 2012 - 7:42 PM

    @Veerkar – Thanks a ton for a detailed explanation. Very helpful. I will read through the link you sent me (it’ll take some time – quite a lot of legalese out there 🙂 ) This is wonderful stuff.

    However, your statement –

    “In case of N3 though you receive 120 as interest from the company you need to declare only 120-96 =24( if your purchase price is 1096 as you have mentioned ) as interest and your tax liability is 7.20 rupees.”

    Really? I mean, I can do this every single time and bump my XIRR. I think interest was taxed at marginal rate to avoid this kind of calculation. I will read up on the ‘act’ and come back on this. If what you are saying is correct, very interesting possibilities emerge.

    Thanks for this. Keep visiting and share your wisdom.

  14. #14 by Ankur Jain on February 21, 2012 - 11:00 PM

    Hi Kiran,

    I got to speak to the deputy company secretary of Tata Capital. The interest rate for the period beyond March 5, 2012 till the early redemption period (estimated date April 20,2012) would be the existing rate only (12% for Option 3 and likewise) and not the reduced rate.

    Regards

    Ankur

  15. #15 by Kiran on February 22, 2012 - 8:38 PM

    @Ankur – Thanks for the update.
    Totally makes sense. In fact, it would be unethical not to do so. The IRR bumps up. Nice. (still not good for the retail investor..but hey…some investors earn the extra).

  16. #16 by RamMohan on September 26, 2012 - 7:16 PM

    @Veerkar
    your posts #7 and #12 are contradictory. Tax treatment on cumulative NCDs in my view ought to be taxed as LTCG (if held for more than a year), whether you sell it or hold till maturity. In other words, I would tend to agree with your post #7. Even the prospectus of Tata Capital talks of LTCG on capital gains. The realisation from selling less what you paid to acquire would equal capital gains, isn’t it?

  17. #17 by www.chinasingels.com on April 26, 2013 - 6:36 AM

    Oh my goodness! Impressive article dude! Thanks, However I am having
    difficulties with your RSS. I don’t understand the reason why I am unable to subscribe to it. Is there anybody getting identical RSS problems? Anybody who knows the solution can you kindly respond? Thanx!!

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