Market Linked Debentures (MLDs): A Wolf In Sheep’s Clothing?

By: Tavaga Research

MLDs may seem appealing and attractive due to their higher post-tax return. But is it really simple and worth investing the money in?

MLDs return is linked to the return of some reference entity like Nifty and its payoff is asymmetrical similar to a derivative product. Imagine if the higher interest on fixed deposit was linked to a sunny day and no rates if the day was rainy. The instrument’s main advantage is that it provides tax savings. However, given the complexity, it becomes necessary to know the nature and suitability of these instruments before investing in them.

MLDs have been considered as a way out of regulatory limitations in the Indian bond market. MLDs are not issued in their true sense, but rather as a ruse to gain a regulatory advantage over plain-vanilla debentures.

Fixed Income Market in India

The capital market in India is essential for the well-functioning of an economy. It is used by corporations and investors to raise money in the primary market and trade securities in the secondary market. Capital can be issued through equities or debt instruments. 

The debt market in India, also known as the Fixed Income market or bond market is the market where different forms, types, and features of fixed income securities are issued and traded. Generally, Central government, State government, Public Sector Undertakings, Corporate entities, Municipal Corporations, etc issue these instruments. 

These are called Fixed income securities as they offer a fixed rate of return (interest rate) annually, quarterly, or monthly along with the principal amount at the end of the maturity period. They can be issued for 1 year to as long as 40 years.

 Some of the examples of fixed income financial instruments are NHAI Bonds, 75% RBI tax-free Bonds, REC Bonds, L&T Finance Limited Bonds, etc.  

The bond market in India is hugely dominated by Government Bonds (G-Secs) issued by the RBI on behalf of the Government of India. However private players also issue corporate bonds of varying maturity and interests. 

G-Secs account for 50 – 75% of the market capitalization and trading volumes in India and around the world. Approximately, 70-75% of the value outstanding of the issued securities and 90-95% of the volume trading, account for Government securities (G-Secs). Currently, the market is concentrated as the top 10 liquid outstanding government securities account for 70% of the daily trading volumes.

The Fixed Income market is regulated jointly by the Securities and Exchange Board of India (SEBI) and Reserve Bank of India (RBI).

Investors in Fixed Income Market

There are mainly two types of investors in Fixed Income Market:

• Retail Investors
• Institutional Investors and High Net Worth Individuals (HNIs)

Mainly banks and institutional investors such as Financial Institutions, Provident Funds, Mutual Funds, Banks, NBFCs, High Net Worth Individuals, Municipal Corporations, Central and State governments invest in the fixed income market.

Participation by retail investors is almost negligible if at all through Mutual funds. The Reserve Bank, however, has recently allowed retail investors to directly participate through their platform to invest in government securities. This move has opened up various avenues for small investors whereby they can invest in government securities with 5-year maturity as well. It will help deepen the market and increase its liquidity. 

Presently, approximately, 39% of outstanding government securities were held by banks, 25% by insurance companies, 15% by RBI, 5% by the provident fund, and FII and mutual funds held 2% each.

What are Market Linked Debentures?

Market Linked Debentures (MLD) are the fixed income instruments whose return is linked to either a particular security or market Index such as government security, gold index fund, or Nifty Index fund. 

Let us consider an example, 

• Company X wants to raise 5 crore worth of capital so it decided to issue an MLD.
• Company X offered to pay an interest of 8% on the condition that the price of government security will not fall below 20%.
• Now, if the price of the government security doesn’t fall below 20% the investor will get 8% interest along with the principal on maturity.
• However, if the condition is not fulfilled then the investor will lose its interest payment and will be paid principal only. These are often referred to as Principal Protected MLDs.

It’s almost like betting on the market, equities, or government securities to get indirect exposure to such markets and higher returns. Their maturity ranges from 1 to 5 years. They can be listed as well as unlisted and secured by collateral or unsecured. It is regulated by SEBI. 

These instruments are complex and require a minimum investment of 25 lakhs or more, therefore it’s not suitable for retail investors with a low-risk appetite. High Net Worth Individuals looking to diversify their portfolio or in search of higher returns with the ability to take risks can invest in these structured instruments.

MLDs are generally sold by investment banks and distributors who get 1 or 2% commission for their services and are issued through an offline mode. They might also be available on an exchange but are highly illiquid and rarely traded on these exchanges.

Which Companies are offering MLDs

Many NBFCs have become popular among high-net-worth individuals for investing in MLDs. Corporations with a minimum net worth of 100 crores generally issue such securities. Some of the financial institutions who have offered MLDs in the past:

What are the Benefits?

One of the major benefits of investing in MLDs is the tax savings for High-Net-Worth Individuals (HNIs). As per the regulations, 10% of the tax is applicable on long-term capital gains for listed bonds held for more than a year. Therefore, listed MLDs are tax-efficient. 

For instance, if you sell 8% MLD after a year in the secondary market you can earn 7.2% in return as compared to a fixed deposit which is taxed at 30% for a person in that tax bracket effectively making 5.6% post tax on 8% fixed deposit. However, this scenario won’t work if the instrument is held till maturity as it will not be tax efficient then. For this reason, some of the companies make arrangements to buy them before maturity so that investors can avail tax advantage.

● MLDs allow one to participate in the upside of the market without having to worry about the downside risk. In Principal Protected MLDs, the maximum an investor can lose is the interest income conditioned on the market index or government securities. However, they will get their principal back which sort of provides a cushion for them against the downside of the market.

● It indirectly provides access to other markets such as the equity market, gold market, government securities market, etc.

Advantages of MLDs over other Debentures for Issuers

• No Liquidity crunch as there is no fixed regular payment of coupon during the tenure of MLDs
• Issuers are allowed to issue 5 additional ISINs over and above the limit of 12 ISINs in a financial year in case of non-convertible debenture.
• MLDs help issuers comply with SEBI guidelines on fund raising by issuance of Debt Securities by Large Entities (25% of borrowing via Capital market).
• Exemption from Electronic book mechanism for issuance of securities on private placement basis. This is one of the major reasons that issuers choose MLDs for fund raising.

Where’s the Risk?

There is no free lunch. And in the world of finance, this philosophy is engraved in stone. The attractive post tax return comes with a cost- the risk. 

• Credit Risk: With such instruments there will always be a risk of the company defaulting on either its interest payments or principal repayment leading to credit risk. One should be cautious while investing in them and look at the credit rating provided to MLDs of various companies.
• Downside Risk: Downside is only protected up to a level of guarantee provided by NBFCs. However, in case of default, one can face severe losses.
• Liquidity Risk: Liquidity risk is also present with such investments. These instruments are usually illiquid and rarely trade on secondary markets.
• Regulatory Risk: In case of change in tax rules, the tax benefit will be withdrawn leaving investors unprotected.
• Complexity Risk: Some of these instruments are extremely complex to decode and won’t be understood easily by amateur investors.
• Investors should also properly analyze the condition on which the interest depends before going in for the investment.

Other Investment low-risk investment alternatives

Short and Long Term Treasury/GOI Bonds– It has high credit quality and high liquidity. However, it provides low yield, and has interest rate risk.

Target Maturity Funds– Target maturity funds are a form of debt fund having a set maturity date that corresponds to the maturity date of the bonds in its portfolio. Such funds, on average, have reduced interest rate risk and offer more predictable and steady returns. As a result, these funds have no risk of default because they invest in government securities and highly rated bonds issued by public firms.

Equity Savings Fund– Investors with a moderate risk appetite might choose equity savings funds, which are hybrid mutual fund schemes. These funds have a lower risk profile than more aggressive hybrid funds such as Hybrid Equity Funds. Low volatility and tax-efficient are the major benefits of an equity savings fund.

Arbitrage Funds– A mutual fund that uses the price disparity in the cash and derivatives markets to generate profits is known as an arbitrage fund. The returns are determined by the asset’s volatility. These funds are hybrid in nature since they allow for a significant percentage of the portfolio to be invested in debt markets. These instruments are a perfect solution for low-risk investors. These funds take advantage of market inefficiencies to make money for their investors. These funds have the same tax treatment as equity funds since they invest primarily in stocks and can be used as an alternative to savings account and liquid funds.

Ending Note

Market Linked Debentures are fascinating instruments that can offer high rates of return as compared to certain fixed-income securities and let you participate in the upside of the equity market Index. But these are complex instruments that should be carefully evaluated before buying into them. If one understands the complexities, has a high-risk appetite, and wants to avail tax advantage can think of investing in this new age Market Linked Instruments.

MLDs may be used as a tool to attain regulatory arbitrage (in the form of relaxations from EBP, ISIN norms, etc.), by using structures where the debentures might ‘appear’ to be market-linked’, but in effect, are not so, as the link itself is illusory.