Should you invest in market-linked debentures in a bear market?

MLDs are hybrid or structured products that invest in both fixed-income and derivative instruments to generate higher returns compared to plain vanilla debt securities. The return earned on these instruments is based on the performance of the underlying index such as Nifty 50 or G-Sec. Even if the underlying index doesn’t perform well, most MLDs offer a guarantee of returning the principal amount. Thus, these are called principle-protected MLDs (PP-MLDs).

Let’s take the Nifty 50 (trading at around 17,300 currently) as the underlying index. A PP-MLD may, for example, offer to pay a coupon of 15% if the Nifty crosses 19,000 at the end of its tenure. In this case, the MLD issuer enters into a derivative contract to some extent with the funds raised, betting on the upward movement of the market to generate higher returns. If the condition is not met, just the principal amount will be repaid by the issuer.

In the above example, even if the Nifty stands at 20,000 or 25,000 on MLD’s maturity date, the coupon is fixed at 15%. Such instruments are called fixed-coupon MLDs. There are MLDs with variable coupon rates as well in which the interest rate is linked to the performance of the underlying index. For instance, say, a PP-MLD offers a coupon with a participation rate of 85%. In this case, if Nifty gains 15% till the maturity date, the variable interest rate will be 12.75% (15%*85%) for the entire tenure of the MLD.

Thus, through well-structured MLDs, one can pocket gains from a rising market while protecting one’s capital. Most MLDs come with a tenure of about 14-60 months.

“A bear market could be a good time to invest in MLDs with a bullish view if they are structured properly. When the market has fallen and if you expect the Nifty to recover in the next two-three years, a variable coupon PP-MLD structure helps in participating in the upside. Even if the view goes wrong, the investor will get back the principal,” said Manish Jeloka, co-head, products & solutions, Sanctum Wealth.

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Note that there is also a non-principal protected MLDs (NPP MLDs) category that offers a higher potential to capture the upside with limited or no downside protection. However, only PP-MLDs listed on the exchange come under the purview of Securities and Exchange Board of India (Sebi) regulations.

The big advantage of MLD instruments is their tax treatment. The return on investment in listed MLDs is taxed as long-term capital gains at 10% if sold in the market after one year. This scores higher compared to the three-year holding period for debt mutual funds taxed at 20% (with indexation) and slab rate tax for interest earned on FDs. But the tax advantage is only when the securities are sold before the maturity. Typically, wealth management firms informally promise clients to ‘buy back’ their MLDs just before maturity to give them the benefit of the 10% LTCG.

Thus, the post-tax returns of MLDs become attractive to those in the higher slab rate. The minimum investment amount of ₹10 lakh into MLDs also makes them accessible only to HNIs. However, if the MLD is held till maturity, the gains will be taxed at the slab rate of the investor, which will bring down the attractiveness of this product even for the high net worth individuals.

Risks

MLDs are considered high-risk because of the linkage of returns to the market performance of the underlying index. The risk of the underlying index not meeting the conditions set forth by a PP-MLD is called market risk. “The derivatives portion of MLDs is structured to generate returns based on bullish, bearish or range bound view on such underlying instruments. For example, an MLD may generate a higher return if Nifty crosses 20,000 by December 2022. If this scenario does not play out, there may be no returns from the structure. This risk is apparent on the face of the product note,” said Harish Menon, co-founder of House of Alpha.

Secondly, the companies raising funds through the MLD are rated mostly in the range of AAA (highest level ranking) to BBB (low ranking). Thus, credit risk—the risk of default or delay in the payment of the maturity amount by the issuer—is significant in MLDs.

Credit risk is why some financial planners shy from recommending MLDs to their clients. “I don’t think MLD structures are bad, but the credit risk these products come with is something I am concerned about,” said Vishal Dhawan, founder & CEO of Plan Ahead Wealth Advisors.

While credit rating given to the issuer is one way to assess the creditworthiness of the issuer, it cannot be confused with the ability of an issuer to pay the coupon, which is dependent on market index. “AAA rating is not for the MLD as a whole but just for the credit portion in that,” said Feroze Azeez,. Deputy CEO, Anand Rathi Private Wealth Management.

Menon also pointed out the counterparty risk these MLDs carry due to trading derivatives on the over-the-counter (OTC) segment, on which trade is done directly between two parties, without the supervision of any exchange (NSE or BSE).

“Options listed on exchanges have limited liquidity beyond 1-year maturity. If the MLD is issued for 3 years, it should ideally have 3-year options embedded in it. For this, the MLD issuerresorts to OTC options that are traded with a specific institutional counterparty. There could be a scenario where this counterparty defaults on the profit payments if the market view goes right and MLD accrues profits,” explained Menon.

Finally, the poor liquidity for these instruments in the secondary market poses a liquidity risk if the investor wants to exit before the maturity date.

Suitability

Considering the complexity of the product structure and the due diligence one needs to do, MLDs are suitable only for well-informed investors who can afford to leave the investment untouched till the maturity date.

Owing to the minimum investment amount of ₹10 lakh, online bond platforms for retail investors such as Wint wealth and BondsIndia are also not actively offering MLD products on their websites.

Even those who can afford the minimum investment amount need to assess the concentration risk of MLDs in their portfolio. “If ₹10 lakh is entirely invested in one MLD issuer, the credit risk is concentrated and revolves around that one particular issuer. If the same ₹10 lakh is put in a debt mutual fund, it gets diversified across the entire portfolio,” added Vishal Chandiramani, chief operating officer at TrustPlutus.

“MLD is a product that was never created for the retail market or for a common investor. The benefits of MLD is a lot different from what a normal investor seeks,” added Puneet Aggarwal, founder–director at BondsInida. Even in the case of HNIs, the selection of the right MLD matters the most to generate efficient market-linked returns.

Fees

Charges on issuances of MLDs work in a similar manner as the primary issuance of any bond /debenture. Usually, there is no separate charge to the investor. “There is an embedded fee payable by the Issuer to the arranger such as distributors. Thus, there is no direct impact of the fee charged by the issuer on the returns earned by the investor,” said Joydeep Sen, an independent debt market analyst.

According to a study on MLDs, authored by Aanchal Kaur Nagpal and Shreya Masalia of Vinod Kothari Consultants, in January 2021, some MLDs in the past were issued to gain regulatory arbitrage (relaxation from certain compliances) otherwise not available to issuers of plain vanilla debentures.

As per the study, which took into account various case studies (picked from information stock exchange and websites of companies), the downside conditions on which the coupon rate is based are highly unrealistic. “An instance where the value of Nifty or a G-sec would fall by 50-75%—in which case 0% return is paid—seems quite impossible. Hence in almost all conditions, the investor will always be receiving a coupon and thus the hedging shown is more of a hoax. The MLDs are, thus, not market-linked at all, thereby defeating the purpose of introducing these instruments,” the report highlighted.

The study reveals that many MLDs are not market-linked but are in fact equivalent to plain vanilla debentures. Thus, if someone invests in MLDs thinking of capturing upside in the market, it may not be the case. Sometimes, it could be just as investing in an ordinary debt security.