Market Linked Debentures: Who should invest, tax benefits, associated risks – All you need to know
September 20, 2020 10:40 AM
Market-linked debentures can be designed in various forms and can be structured to provide different objectives to sophisticated investors under different conditions.
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With a lot of adjustments in the post-COVID era which we term as the “new normal”, one more addition would be the low interest rate environment. With concerns around growth in the short term, this low interest rate environment may continue to prevail. Talking from an investor’s perspective, while the benefit of declining rate could be seen on a YTD basis in the investor’s portfolio, any fresh allocations to traditional fixed income would carry negative real yields, which makes the traditional investment avenues unattractive.
This quest for higher yield/positive real returns can be fulfilled by adding some degree of risk to the portfolio.
Market-linked debentures (MLD) offered through the private placement route can be a potential solution to provide this yield kicker in the portfolio. Market-linked debentures can be designed in various forms and can be structured to provide different objectives to sophisticated investors under different conditions. One that are predominantly seen in current markets are principal protected fixed income instruments issued by a single issuer which has coupon contingency based on fulfillment of a certain underlying condition.
For example, a 30-month MLD would pay the investor a pre-defined IRR at the end of the tenure if Nifty 50 Index does not fall by more than 75%. The perceived benefit that investors have in a structure like this is:
# Principal protection as opposed to a pure equity investment where there is risk of capital loss.
# Superior return potential vs traditional fixed income on fulfillment of an underlying equity condition.
# Structure which is at a sweet spot versus two traditional asset classes.
While the above example would be that of a simple structure, there are various other complicated structures like (a) principal protected with a participation rate linked to an underlying index, (b) principal protected structures which gives a pay off if equity markets go down, (c) less than 100% principal protection structures etc.
Due to the complexity of structures and higher minimum allocation, these structures are suitable for HNI and UNHI clients who understand the nuances correctly and are offered to them on a private placement basis.
What is very important here is to understand the risk associated with MLDs.
1. Issuer’s Profile: Although a majority of structures are principal protected, the ability of the issuer to repay is of paramount importance. Investors may suffer a capital loss in case the issuer fails to repay on the obligation. Post the ILFS crisis, we have seen some stress in the economy on the credit side through rating downgrades and write offs. This has also affected MLDs issued by such issuers which now trade at a significant discount to par. Thorough due diligence on the issuer’s underlying business, its diversification and key financial ratios should be undertaken before investing.
2. Fulfillment of the underlying market linked condition: Secondly, payment of coupon is contingent on a certain market linked condition. Investors need to place a probability on the fulfillment of the underlying market condition. In our example above, a 75% drawdown is a safe enough condition considering it’s in line with the drawdown during GFC which was a black swan event.
MLDs generally have a bullet repayment at the end of the tenure for both principal and coupon. In case of coupon bearing structures, the rate of coupon is contingent on the credit quality of the issuer. As we go down the rating chain, the interest rate goes higher. MLDs also get listed on the stock exchange which may provide intermittent liquidity in some cases. Listed MLDs are tax efficient as compared to traditional fixed income options which are taxed at marginal rates. MLDs are currently taxed at 10% plus surcharge which makes them tax efficient specially for higher income bracket investors.
HNI & UHNI investors who have a risk profile allowing investment in sophisticated high risk products and who can meet the minimum investment ticket size could look out on selective basis to add fixed income type MLDs as a 5% to 10% allocation within the fixed income part of their portfolio. This will enhance the portfolio yield in a tax-efficient manner, subject to performance conditions being met, which could benefit the investors and help them earn a positive real return in the current scenario.