Hedge against volatility:: Business Line,

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Shareholders of fertiliser producer Coromandel International can now hedge any volatility in their stock prices caused by market swings, with a fixed return instrument from the same company. To commemorate its golden jubilee year, the company plans to issue unsecured redeemable bonus debentures to its investors. The debenture will carry an interest rate not exceeding 9 per cent per annum. The tenure of the debenture is yet to be disclosed.

This reward to shareholders is different from the bonus shares or ‘special' dividends that cash-rich companies typically offer. Only a few companies, such as Hindustan Unilever, Britannia Industries and, more recently, Dr Reddy's Lab, have rewarded investors in this manner. Here's our take on how different this instrument is in terms of risks as well as taxability for an investor.

LESS RISKY

To start with, the debenture is offered as a bonus to investors, implying that shareholders get it for free. The debenture will earn a fixed annual interest income and will be redeemed at the time of its maturity. Alternatively, since these instruments are typically traded on the stock exchanges, debentures can also be sold on the bourses provided there is sufficient liquidity for the same. A passive investor, though, may choose to hold the same until the company redeems it to avoid the risk of wrongly timing an exit, as market prices of such debentures may fall too. In the present volatile market condition, a bonus debenture may be a more secure option than bonus shares. While a share is exposed to equity market swings, the interest on the debenture will provide a steady return. Remember, debentures are backed by reserves and will receive priority in repayment (over equity shares) if a company goes into liquidation. They are therefore, a good hedge for shareholders in the same company, especially when the debenture is issued free of cost to investors.

Coromandel too, benefits from the issue in two ways. One, it defers the cash outflow until maturity of the debenture. Until then, it treats the debenture as debt, paying only the interest. This appears to be a wise move, given the low debt on Coromandel's books and high cost of borrowing outside. Two, and more importantly, it prevents needless expansion of capital and in fact, improves return on equity (as reserves are shifted to debt) thus improving shareholder value.

TAXABILITY

The tax that investors suffer always plays a big role in determining how attractive an instrument is. In the case of bonus debentures, the interest income is taxed like any other income under the investor's normal tax slab. On redemption, though, experts reckon that the difference between the redemption/sale value and the cost (the value at the time of allotment) is taxed as short-term or long-term capital gain, depending on whether the holding period is less than a year or more.

It is noteworthy that while bonus shares have nil cost in the shareholder's hands, bonus debentures do have a cost. Experts say that this would be the case as the bonus debenture value would have already suffered tax at the time of issue; companies pay dividend distribution tax on the bonus debenture value as they are deemed to be dividend.

Hence, if the redemption value is, say, Rs 1,000 and the cost at the time of allotment is Rs 1000, investors would not suffer capital gains.

To sum up, in the proposed Coromandel issue, if investors receive interest payouts and hold till maturity, they are unlikely to suffer capital gains tax.