What are Market Linked Debentures?
Market linked debentures (MLDs) are a type of debt instruments that offer returns based on the performance of an underlying market index or instrument. They are issued by companies or financial institutions to raise funds from investors who are willing to take some market risk for higher returns.
Previously, market-linked debentures (MLDs) had a face value of INR 10 lakhs, making them an attractive option for high-net-worth individuals (HNIs). However, since January 1, 2023, SEBI has reduced the face value to INR 1 lakh, making it easy for individual investors also to purchase MLDs.
Features of Market Linked Debentures
Some of the common features of MLDs are:
- They are non-convertible debentures, meaning they cannot be converted into equity shares of the issuer.
- Unlike traditional bonds, MLDs do not have a fixed maturity date. The tenor of MLDs is decided by the issuer and can be dependent on the underlying index or security.
- They are rated by credit rating agencies to indicate the credit risk of the issuer. The higher the rating, the lower the risk of default.
- They have a minimum investment amount of INR 1,00,000. Prior to Jan 1 2023, it eas INR 10,00,000.
- They are regulated by the Securities and Exchange Board of India (SEBI) and have to comply with its guidelines and disclosures.
- MLDs that are listed on the stock exchange can offer intermittent liquidity. However, the actual liquidity of MLDs depends on market conditions and the number of buyers and sellers. On the other hand, non-listed MLDs with lower credit ratings may offer limited liquidity compared to their listed counterparts.
- They are taxed as capital gains if sold in the market after one year. The tax rate is 10% without indexation or 20% with indexation. However, from April 1, 2023, both listed and unlisted MLDs will be taxed at slab rate as per the Budget 2023 proposal. They are also subject to TDS at 10% on interest income from April 1, 2023.
How Do Market Linked Debentures Work in India?
MLDs are issued by companies or financial institutions through a private placement route. They have a fixed maturity period ranging from 12 to 60 months. The returns on MLDs are not fixed but depend on the movement of an underlying market index or instrument, such as equity benchmark, government yield, gold index, etc. The underlying index or instrument is specified in the scheme document of the MLD. The returns on MLDs are paid at maturity along with the principal amount.
For example, a company may issue an MLD that pays a return of 10% per annum if the Nifty 50 index does not fall by more than 20% during the tenure of the MLD. If the Nifty 50 index falls by more than 20%, the investor will get only the principal amount back. On the other hand, if the Nifty 50 index rises by more than 20%, the investor will get a return of 10% per annum plus the excess return over 20%.
Types of Market-Linked Debentures
There are two main types of MLDs based on the principal protection feature:
- Principal protected MLDs: These MLDs guarantee the repayment of the principal amount irrespective of the market performance. They offer a downside protection to investors in case of adverse market movements. However, they also limit the upside potential in case of favorable market movements.
- Non-principal protected MLDs: These MLDs do not guarantee the repayment of the principal amount and expose investors to market risk. They offer a higher return potential than principal protected MLDs but also carry a higher risk of capital loss.
Who Should Invest in Market Linked Debentures?
MLDs are suitable for investors who:
- Have a high risk appetite and can tolerate market volatility
- Have a long term investment horizon and can hold till maturity
- Have a good understanding of the underlying market index or instrument and its dynamics
- Are looking for higher returns than traditional fixed income instruments
Advantages of Market Linked Debentures
Some of the advantages of MLDs are:
- Higher Returns: They offer an opportunity to earn higher returns than fixed-income products if the underlying benchmark performs well. For example, if you invest in an MLD that pays a coupon of 10% per year if the Nifty 50 index rises by more than 15% from its initial level at maturity, you can earn a handsome return if the index does well. On the other hand, if you invest in a fixed deposit that pays 6% per year, you will get only that much return, irrespective of how the market performs.
- Diversification: They provide exposure to different asset classes and markets through a single instrument. For example, if you invest in an MLD that pays a coupon based on the performance of gold prices, you can gain exposure to gold without actually buying physical gold or gold ETFs. Similarly, if you invest in an MLD that pays a coupon based on the performance of the US dollar exchange rate, you can gain exposure to foreign currency without actually buying dollars or currency derivatives.
- Multiple Options: They allow investors to customize their risk-return profile according to their preferences and expectations. For example, if you are bullish on the equity market, you can invest in an MLD that pays a higher coupon if the equity index rises by more than a certain percentage. If you are bearish on the equity market, you can invest in an MLD that pays a higher coupon if the equity index falls by more than a certain percentage. You can also choose between principal-protected and non-principal-protected MLDs, depending on your risk appetite.
- No Reinvestment Risk: They have a fixed maturity period and do not have reinvestment risk.
Risks of Market Linked Debentures
Some of the risks associated with MLDs are:
- Credit risk: Refers to the possibility of issuer default or becoming insolvent, resulting in a loss of both the principal and the coupon payments. This depends on the rating of the instrument and the financial strength of the issuer. Credit ratings of MLDs can be AAA followed by AA+, AA, AA- and BBB. Lower-rated MLDs indicate lower creditworthiness of the borrower. Furthermore, MLDs are not covered under the Deposit Insurance and Credit Guarantee Corporation (DICGC). Thus, in case of default by the issuer, investors may lose their entire investment.
- Liquidity risk: MLDs have a fixed tenure, and the payoff is acquired only at maturity. This means that if you need to exit before maturity, you may face difficulty in finding a buyer or may have to sell at a discount. The liquidity and price discovery of MLDs depends on various factors such as demand and supply, market conditions, credit rating, structure, and the availability of a secondary market. Therefore, it is advisable to invest in MLDs only if you can hold them till maturity.
- Market risk: Arises from the fact that coupon payments in MLDs are based on certain market-linked conditions. If the underlying benchmark performs poorly or does not meet predefined criteria, you may receive lower or no coupon payments, despite the principal being protected. Thus, it is important to understand the payoff structure and the market scenario of the MLD before investing.
- Complex: MLDs are complex instruments that may involve various parameters that may not be easy to understand or predict. The valuation of MLDs may also vary depending on the methodology used by different agencies. Thus, it is recommended to seek professional advice or guidance before investing in MLDs.
Frequently Asked Questions
Yes, market linked debentures can be sold before maturity on the stock exchange. However, the price of the debenture may fluctuate depending on the performance of the underlying index.
The returns on market linked debentures are taxed as per the income tax slab of the investor.
The underlying index for MLDs can be Nifty, bank nifty, 10-year government bonds, and gold.
MLDs are generally distributed by investment banks or intermediaries who receive a commission (usually between 1% and 2% of the entry load) for their distribution. While it is possible to buy MLDs from exchanges, the market for MLD trading is not very active.