SLATE. All you wanted to know about: Bonus Debentures

Who doesn’t love a bonus? Usually, for equity investors, bonuses come in free shares. But last week, NTPC cleared the issue of bonus debentures to its shareholders. The markets were quite happy with this and stock shot higher by 7 per cent for the day.

A bonus debenture is a free debt instrument issued to a company’s shareholders as a reward. When the company declares a bonus debenture, you will receive bonds from the company for a specific face value. Interest will be paid on these debentures every year. They will be redeemed after a specific period, when you will receive a lump-sum payment. Take NTPC’s case. Suppose you hold 100 shares of the company, you will receive 100 debentures with a face value of ₹12.5 each, valued at ₹1,250. The interest paid on this debenture is a floating rate. The interest rate is pegged 50 basis points higher than the prevailing yield of 10-year government bonds. The debentures are valid for 10 years and will be redeemed in three instalments at the end of which you would have received ₹1,250.

Only a few companies have issued bonus debentures in the past — Hindustan Unilever, Britannia, Blue Dart Express and Dr Reddy’s Labs.

Bonus debentures serve many purposes. One, as the debentures are redeemed after many years, the company will not see its reserves deplete drastically at one go as is the case with bonus shares. The company will be able to hold on to them for expansion projects. Two, it manages to ‘borrow’ from shareholders at lower rates. Three, the interest paid is claimed as an expense and tax incidence will reduce. Shareholders get free interest-earning bonds. The debentures are fully secured. Companies can also list the debentures on the exchanges and you can sell them in the markets if you need cash. Unlike bonus shares, a bonus debenture issue does not increase the equity share base, which dents the earnings per share. They do not squeeze return on equity, or bump up valuations.

Bonus debentures do sound like an all-round winner, but they’re not. Here’s the flip side. When your company declares a bonus share issue, the entire lot of shares is credited to you at zero cost. If you sell them, you can stand to make gains. These gains are tax-free if you hold them for a year, as they are equity instruments.

But for bonus debentures, the redemption amount will come in only at the end of the period, which can be long. In NTPC’s case, given that the interest is linked to G-Sec yields, the amount you receive will fluctuate and is uncertain. Bonus debentures also don’t enjoy similar tax breaks to bonus shares. First, under Income Tax rules, the amount of the bonus issue is considered to be ‘deemed dividend’ and will attract dividend distribution tax. Two, the interest will be taxable in your hands at your slab rate just like your fixed deposit interest.

Next, even if you can exit debentures on the exchanges, it’s hard to do so in reality due to lack of trading volumes. Assuming that you do manage to exit at a profit, short-term or long-term capital gains tax will apply. But in order to calculate the gains, it’s unclear on what exactly constitutes acquisition cost.

Something is better than nothing and bonus debentures, for all their negatives, at least let you get your hands on the company’s idle reserves.

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