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 –

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 –

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 –

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 –

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

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.