Special Situation: The Return of the Bonus Debenture

Update: The trade was completed. A bond with a face value worth Rs. 15/- was acquired at an average price of Rs. 4/- resulting in a terrific return. But as stated in the post, there was a bit of speculation in this trade and hence I had restricted it to only 1% of my portfolio. 

The title of the post obviously inspired from one of my favorite Star Wars movies, The Return of the Jedi.

Let me state the opportunity first and then move on to the logic of Bonus debentures.

Coromandel International had announced way back in October 2011 that they wanted to issue bonus debentures (unsecured redeemable non-convertible bonus debentures) to its shareholders as part of their Golden Jubilee (50) year celebrations. According to the latest announcement on 6-July-2012, a shareholder would get 1 bonus debenture (free) for every share held. These debentures would have a face value of Rs. 15/-, with a coupon rate of 9% p.a and would have a tenor of 48 months. The redemption would happen in 3 equal installments at the end of 2nd year, 3rd year and 4th year (along with interest on the remaining principal) (that is, you would be paid Rs. 6.35/- on 13th July 2014, Rs. 5.90 on 13th July 2015 and Rs. 5.45 on 13th July 2016 for a sum total of Rs. 17.7/-). These bonus debentures would be listed on NSE/BSE.

The trade was to buy at around Rs. 265 levels (already done by me) on say 09th/10th July and sell on ex-date 13th July 2012 at around Rs. 260 levels (will do tomorrow). There is also a dividend that has been announced (Rs. 3/-) and the ex-date of this dividend is the same as ex-date for bonus debentures (13th July). The bet is that the market would ignore/hardly correct because of bonus debentures (based on similar past corporate actions; explained below) and correct only to the extent of dividend paid, and we would pocket a Rs. 15/- worth debenture along with a 9% interest for the next 4 years for free.

Let’s not get too greedy. Let’s not say the acquisition price would be free. Realistically, let’s say your acquisition cost of the bonus debenture is Rs. 10/- i.e., share price corrects from Rs. 265/- to Rs. 252 tomorrow (Rs. 3 of dividend + Rs. 10 due to bonus debenture) (if it is Rs. 5/-, even bigger reason to celebrate and you can bump up your IRR by so much; if it is free, you can dance to Himesh Reshammiyya’s music) and as usual, you have to pay tax on the interest received on bonus debenture every year (say 30% tax). The IRR is as listed below –

Date	Schedule (after tax on interest)
12-Jul-12	-10
12-Jul-14	5.95
12-Jul-15	5.63
12-Jul-16	5.31
IRR	20%

If you are in for fancy, you can hold on to this debenture and redeem it at the end of 4th year. An IRR of 20% is pretty amazing if you ask me. Coromandel International of course is well funded and is from the well-known and reputable Murugappa group (a cursory look at their history in P&L and Balance Sheet management attests to this fact). Therefore, redemption of these debentures (along with interest), unless there is Black Swan event, shouldn’t be a problem.

Depending on how much the stock correct by tomorrow, I plan to sell these debentures once they list and thereby generate approx 5% returns in the space of a month (from 13th July to listing, say 13th August) (one month period to list, based on past experiences).

The position size is restricted to 1% of my portfolio since there is an element of speculation in this (the stock price might correct severely throwing paani on my hare-brained scheme and the returns might be 0%).

If the trade goes right, 5% returns in a month after brokerage costs. Most probable scenario 20% IRR. Else, 0% returns. Heads I win, Tails I don’t lose much.

With the opportunity of making returns out of the way, let’s look at the logic and history of bonus debentures and why I think the price might not correct by much due to bonus debenture.

Bonus debentures as a concept was pioneered by HLL way back in 2001 (1:1, FV Rs. 6/-; 9% p.a). Subsequently, there was a long pause on the issue of bonus debentures before AstraZeneca introduced it in January 2008 (1:1; FV Rs. 25/-; 8% p.a). There were two more issues in 2010, one by Britannia Industries (1:1; FV Rs.170/-; 8.25% p.a) and the other by Dr Reddy Laboratories (1:6; FV Rs. 5/-; 9.25% p.a). In all these issues/corporate actions, the share price didn’t correct to the extent of the face value of the debenture (obvious reason being that the cash inflow for the investor will start only at the end of 2nd year, like in Coromandel International’s case and that too, only partly) (except in Astrazeneca’s case where the debenture had a tenor of only 1 year). There was also a debenture issue as part of a rights issue in Jyoti Structures, also a case where the share price didn’t correct by the value of debenture issued on ex-date.

Logic of Bonus Debenture: For taxation purposes, bonus debentures are treated as a deemed-dividend (that is, the companies pay out a dividend distribution tax when they issue these certificates, while it is tax-free in the hands of the investor). A note of caution: only the face value of bonus debenture is tax-free, the interest on the bonus debenture is taxable at marginal rate.

For the issue of bonus debentures, the company has to go through court approvals and some processes for listing the debentures. Why do companies opt for the issuance of bonus debentures inspite of all this jhig-jhig (trouble) instead of issuing a dividend? There are two reasons –

a) The interest paid on the bonus debentures is tax-deductible for the company

b) The cash outflow for the company starts only later, unlike a dividend where there is a cash outflow on an immediate basis.

All said and done, companies usually prefer the dividend route or the bonus shares route rather than the bonus debenture route (and hence analysis of bonus debenture is actually a ‘special’ situation 😉 ). Very quickly, let me quickly compare bonus debentures vs bonus shares/dividend to explain why companies usually take the bonus shares/dividend route rather than the bonus debenture route.

Bonus Debentures vs Bonus shares: In bonus shares, the equity of the company does not get altered. However, in case of bonus debentures, the company converts part equity into debt. If it is a highly leveraged company already, then this increased leverage might attract negative attention. Also, in case of bonus debentures (unlike bonus shares), there are three cash outflows – redemption principal, interest and dividend distribution tax.

Bonus Debentures vs Dividend: Bonus debentures as stated earlier have to go through legal proceedings and processes unlike dividend. Dividend though has an immediate cash outflow (and hence immediate cash inflow for investors) unlike bonus debentures. Therefore, shareholders treat dividend-paying stocks more kindly than companies which issue bonus debentures.

Let me know your thoughts on this special situation. Feedback invited.