Personal Finance

How market-linked debentures combine the qualities of equity and debt

Joydeep Sen | Updated on May 01, 2021

The ultra rich now have a wider basket of market-linked debentures to choose from

In bonds, the returns are known upfront. At the other extreme are equity investments, where returns are uncertain. Market-linked debentures (MLDs) combine the two. MLDs are bonds/debentures where the coupon or interest payout is not defined as in the usual bonds. The ‘payout’, which is your return from the instrument, is made contingent upon the movement in another market, referred to as the underlying. The underlying can be an index or a stock or any other asset such as the Nifty, Sensex, any basket of stocks, government security or gold, to name a few. The advantage is, you get the benefit of investing in another market by simply buying a debenture.

They provide principal protection (PP) i.e. irrespective of the movement in the underlying market, you will get principal back on maturity. So, your downside in a PP structure is capped because worst possible return is zero. The upside depends on the movement in the underlying and MLD terms.

Two options

A point to be noted is that under certain structures of the product, the linkage with the underlying market is real. In certain other products, the conditionality of linkage with the underlying market is designed with a low probability, so that you have a high degree of certainty on returns. The latter are referred to as fixed-income-oriented structures and are more popular. Here, while there is a linkage with an underlying, the conditionality is kept in such a manner that the probability of getting the indicated return (XIRR) is near-certain. In real market-oriented structures, the pay-off is contingent upon the movement of the underlying.

More than 80 per cent of the issuances in the market are fixed income-oriented. As an illustration, a fixed income-oriented MLD can have a condition that if the Nifty as the underlying does not fall 75 per cent from the initial level or the price of 10-year government bond does not fall by 75 per cent, then the investor will get the indicated return. This condition being highly unlikely, the investor can visualise the return. In a real market-oriented structure, the terms would state something like this — if the Nifty goes up by X per cent, the investor would get 75 per cent of the upside.

Tax efficiency

MLDs are tax-efficient. There is no coupon payment, as they are by definition dependent on the underlying market movement. Principal protected structures are listed on exchanges and hence over a holding period of more than 1 year, become eligible for long term capital gains taxation (10 per cent plus surcharge and cess.

Compared to regular bonds, there is significant tax efficiency. Bond coupons and the usual zero-coupon bonds are taxed at the marginal slab rate i.e. 30 per cent plus surcharge and cess. The tenure of MLDs has to be a minimum of one year from a tax-efficiency perspective, which is the LTCG horizon required for listed bonds. Usually the tenure ranges from 15 months to a tad over three years. These are an HNI product and are not meant for retail investors. While there is no legally defined minimum ticket size (like ₹50 lakh in PMS), wealth management outfits would like to sell in ticket sizes of, say, ₹1 crore. But, the ticket size may vary. It depends on the face value also. If the face value is ₹10 lakh, it goes in multiples of 10 lakh.

The risk factors in MLDs are two-fold: (a) default risk, which can be gauged from the credit rating and (b) liquidity, there is no liquidity in the secondary market. Hence, if you need to redeem prior to maturity, there may not be a buyer. Nowadays, there are many issuers hitting the market. The presence of a PSU issuer rated AAA in this space, such as the Rural Electrification Corporation, implies that the concept of MLDs has the implicit support of the Government.

Some of the new private sector issuers hitting this segment are Shriram Transport Finance, Muthoot Fincorp, Shriram City Union, Hinduja Leyland Finance, Manappuram Finance and M&M Financial Services. This product is largely meant for HNIs and is yet to be made available in retail lot sizes. The issuances take place through private placements (as against public issues). Investors can avail of this product from wealth managers and a few select bond houses.

The author is a corporate trainer and author

Published on May 01, 2021

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