A few months back, I decided to explore the secondary market for bonds, particularly Non-Convertible Debentures. I purchased some Shriram bonds through my ICICI Direct account. These debentures were set to be redeemed in just 3 months. The surprising part? I managed to earn a neat 10%+ yield (pre tax)ton my investment within this short span – all before taxes, of course.
NCDs: A Simple Introduction Think of NCDs as loans that you extend to companies. In return, they promise to repay your invested amount with a little extra as interest. These debentures can be bought and sold just like stocks in the market. NCDs pay interest (and not divodend like shares), and have a fixed interest rate that is announced when they are issued. Depending on the NCD terms, interest (at what is called the "coupon rate") may be paid monthly, quarterly, annually or cumulatively during maturity - Bank Fixed Deposits also offer such options, so this is no different. I use the word bond interchangeably with NCD in this blog post.
Okay, Yield vs Coupon rate - say what?
This requires a separate blog post, so refer this blog post here
So Why did it happen? On the face of it, the reason was because the bond was trading at a price where the yield was high.
So, why is it trading so low? Could be for many reasons - bond pricing is a science by itself, but in retail markets, it could happen because people need liquid cash and are willing to exit asap.
Another thing I realized is, It also boils down to how NCDs are taxed in India. If you hold onto your NCDs until they mature, any profits are treated as interest income and taxed at your regular income tax rate. But here's the catch: by selling your NCDs in the secondary market just before maturity, you can enjoy a more favorable tax treatment. This is especially true for NCDs/bonds in the last year as well as for those which have a cumulative interest option
Cracking the Tax Code Let's break down the tax part, without the jargon:
Holding NCDs to maturity leads to gains classified as interest and taxed at your normal rate.
Selling before maturity means your gains are treated as long-term capital gains, with a lower tax rate of 10.3%. (I acually took this out from L&T Finance's bond prospectus where they explicitly mention the assumption!)
How does this actually work?
I used the actual NCD that I bought in the secondary market to illustrate this example
Ms X bought Shriram Transport Finance Deposit's bond in July 2018, at a face value of ₹1,000. The bonds are due to mature on 12 July 2023. The maturity amount for that bond was published as ₹1,567.45.
Let us model post tax return that Ms X for both scenarios: 1) Where she holds to maturity 2) Where she sold the bond to me on NSE at ₹1515 on 21 March 2023
Note: I used 24.7% as effective tax rate based on someone with ₹25Lacs of net taxable income, but higher the taxable income, lower the gains post tax in case of holding to maturity.
Where is the short term opportunity?
Well, remember that I bought this bond from Ms X. How much did I make post tax?
Caveats and Considerations
Before jumping in, it's important to note that this strategy is most effective for NCDs offering a cumulative interest option. However, sometimes good bargains can be found across various NCDs. To make the most of this opportunity, keep the following points in mind:
Accurate Yield Calculation: When assessing potential gains, ensure that the yield calculation is accurate. Sometimes, the numbers presented might not factor in all costs or may make assumptions that don't match your investment situation.
Partial Redemption Impact: Check if the NCD has already been partially redeemed. If it has, the yield calculation might be incorrect unless the partial redemption is considered. This can significantly impact your expected returns.
Brokerage costs: ICICI Direct charged high brokerage, so my effective return was 7.8%. However the same in Zerodha is so low it is negligible.
Bond rating: I stick to bonds rated above A by ICRA or CRISIL. But bear in mind higher the risk, higher the reward, but also higher the default risk.
In a Nutshell: My Personal Takeaway
This journey into NCDs through the secondary market was truly an eye-opener. It showed me that even in the realm of finance, there are simple yet effective strategies that can yield impressive returns. Remember, while this tactic worked for me, each financial decision comes with its own set of considerations and risks. Always consult with a financial advisor or tax expert before making investment choices.
In the end, this experience highlighted that a little knowledge and a calculated approach can go a long way in optimizing your financial gains. So, if you're up for a little adventure in the world of finance, consider exploring the potential of NCDs – a simple strategy that could lead to surprising profits.
PS: If you invested in NCDs in their initial offerings or on the secondary market with more than 3 years to maturity, consider selling them before maturity based on the logic I explained above