How IT strippers behave

SMARTSHARE

Last year, the IT department plugged an important loophole when it lengthened the holding period for dividend-stripping schemes.

The modus operandi of a dividend strip is as follows: Take a short-term position in a mutual fund with tax-free dividends. Collect the dividend and sell the ex-dividend unit.

The ex-dividend NAV will drop to reflect the dividend payout. The capital loss of the ex-dividend units against the cum-dividend units is offset in capital gains tax while the dividend itself is tax-free.

Until recently, the "stripper" could buy the units on, or just before, the record date, and sell immediately afterwards. Last year, the IT department stipulated that the units must be held for a minimum period of 90 days before record date (or nine months after the record date) for tax benefits to apply.

That has provoked all sorts of action in the debt and derivatives markets. Take a standard case. To offset say, Rs 10 lakh in tax-incidence, let's say it's necessary to buy approximately Rs 1 crore worth of units in an index fund and hold for 90 days.

Thus, it may be necessary to borrow to do the initial deal. If the leveraging is based on the value of the index fund position, there could be margin calls as well.

The units will fluctuate in value. It's prudent to hedge the strip-fund position over a 90-day period. Most record dates fall within 90 days of the Budget, which is the most volatile of time-periods in a normal year.

A catastrophic post-Budget drop in index values could wipe out all profits and even lead to net loss. But a fully hedged position may cost more than the original tax liability.

So a dividend-stripper is now taking on market risk across debt, derivatives and stock-indices. It's just the kind of situation, when financial whiz-kids spit on their hands in glee and churn out all exotic hedging-cum-leveraging models. Over time, I suspect that stripping will add a new, interesting, set of dynamics to the final quarter of each fiscal.

The impact on the derivatives market is benign "" open interest volumes rise in hedging scenarios when the stripping seems profitable.

Fund managers will also be happy that there is no instantaneous churn since it makes redemption management easier.

The impact on the debt market could be mixed. It seems obvious now that the RBI is set to let interest rates rise. The reverse repo hike has led to an instant jump in short-term (91-Day) T-Bill yields.

Under most scenarios, the rate rise should continue to feed through the system well into 2007. If there's a bulge in short-term debt in the fourth quarter of 2005-06 or of 2006-07, there could be odd inversions of the yield curve.

The rate rise itself creates an interesting scenario for the long-term investor. The standard advice in such situations is to divest debt funds, finance and banking stocks and avoid corporates with large capital requirements.

In a high-growth economy, most corporates have high capital requirements. Cash-rich companies with low-debt are far and few between and those that fulfill the balance-sheet criteria are generally highly-discounted.

One sleeper could be Bharat Electronics (BEL). It's at a PE for 18, which is acceptable, if not cheap. It has free cash reserves and it is net cash-flow positive. The growth prospects appear reasonable.