Should you invest in market linked debentures?
Structured products offer investors exposure to stocks and indices. However, they must be understood in the context of the investment goals of the investor.
As stock markets rise more and more investors are embracing various options investing in stocks, market linked debentures (MLD) are attracting investors, along with equity mutual funds and portfolio management schemes. With attractive payoffs compared to traditional investment options such as fixed deposits, bonds and non-convertible debentures, MLDs also known as structured products are the buzzword for high networth individuals. “Structured products offer unemotional and mechanical exposure to equities. You should invest in such products if and only if the risk-return offered by such products suits your investment needs,” says Feroze Azeez, deputy CEO - private wealth management, Anand Rathi Financial Services.
MLD is akin to any other debt instrument issued by issuers. The term varies between 15 months to 48 months. The rate of return on these MLD however is not fixed. The payoff is linked to the movement of the underlying – say CNX Nifty index or a stock such as TCS. For example, if an investor buys a two year nifty linked debenture (NLD) offering 120% payoff and Nifty gives 40% returns at the time of maturity, then the investors gets 48% returns. As nifty has given 40% returns, investors will take 120% of 40% = 48% returns. The issuer uses the money so raised through MLD to carry out lending activities, business activities or to make proprietary investments. The issuer either buys or sells options that help him mimic the movement in underlying. As the payoffs are linked to the movement of stocks, there is a possibility of loss, though some MLDs are designed to protect the principal irrespective of the stock market movement.
As per report released by CARE Ratings, the MLD issuances are expected to touch Rs 8200 crore in FY17 as compared to Rs. 4,874 crore in FY16. The rising demand for these products is attributed to lukewarm returns offered by gold, real estate and fixed income. “In addition to the market linked returns, attractive tax treatment makes many investors consider these MLDs,” says Nishant Agarwal, Senior Director & Head - Wealth Advisory Solutions, ASK Wealth Advisors. MLDs are listed on stock exchanges and if held for more than one year the gains are treated at 10.3% rate of tax. This makes the post-tax returns much more attractive as compared to the interest earned on bonds and fixed deposits which is taxed at 30.9%.
Though some tax experts point out that the exchequer can catch you in case of those MLDs where the payoff is almost certain or in addition to the file payoff, there is a coupon being paid in the interim. In such cases the investor cannot claim shelter under long term capital gains and he will have to pay tax as if he has received interest. Though, given the booming markets one may ignore the tax issue for time being and lap up one such offering. However, do not pick one that offers the highest payoff.
“Tax arbitrage cannot be the sole criterion to invest in a structured product. You have to take into account the credit risk,” points out Feroze Azeez. When you are buying MLD you are effectively lending money to the issuer. It is like investing in a company fixed deposit. You should not touch one with low credit rating where there is doubt about return of capital. Investors in such products should be more worried about return of capital than return on capital.
One should also take into account his investment goals and the payoffs offered by MLDs. “Some MLD offer bond like payoffs but offer to protect capital. Some take market risks but offer high participation. Go with those that fit your requirements,” says Abhishek Puglia, Director - Products, IIFL Wealth & Asset Management. He advises keeping 20-30% of one’s fixed income portfolio in MLDs. In case of equity portfolio one should invest up to 5-15% of the money in MLDs.
Structured products offer mechanical payoffs and hence can be used to compliment one’s portfolio. For example, if you have a bullish view on the market and have a large exposure to equity MF and the markets give only 15% returns over next two years, you see your portfolio offering single digit CAGR despite taking high risk. However, if you have bought a structured product that offers to pay high participation (say 200%) for single digit CAGR in Nifty in the two year time frame, then you take home high returns. If you are a conservative investor and want to boost your returns with limited risk, consider going for MLDs offering tad extra returns without taking capital risk.
Though you may be well aware of the credit risk and the risk associated with returns, do not ever ignore the risk associated with liquidity. “Though the MLDs are listed on stock exchanges, the liquidity is very low. Be prepared to hold on to your investments till maturity,” says Abhishek Puglia.Last but the most important one, even if you decide to go for MLD, diversify yourself across issuers. They are like any other bonds and it makes sense to spread your risk.