Death of market-linked bonds leaves HNIs smarting, NBFCs in a lurch

What are market-linked debentures?

MLDs are structured fixed-income instruments that have their returns tied to market benchmarks, usually indices such as the Nifty, prices of commodities such as gold or even a basket of stocks.

In essence, they are fixed-income instruments having the characteristics of derivatives. This makes their tax treatment complicated, unlike a plain vanilla bond.

The Union budget announced that the proceeds of MLDs will be treated as short-term capital gain for taxation, irrespective of the time of transfer, maturity or even early redemption.

So, what changes now?

Until now, the proceeds were treated as long-term capital gain and attracted a tax rate of 10 percent. Short-term capital gain tax is at the applicable slab rate, which is 30 percent for most investors.

“What the budget says is that it would be applicable from April 2024 (or 2023?), so any income that you earn in FY23 will attract STCG,” said Sameer Kaul, managing director and chief executive officer of TrustPlutus Wealth.

Kaul added that this puts the entire stock of MLDs under the radar of STCG. “Only MLDs issued beyond April 2023 should be considered for this tax change,” Kaul said.

MLDs worth about Rs 21,000 crore have been issued since April 2022 by 70 NBFCs, said Krishnan Sitaraman, Senior Director and Deputy Chief Ratings Officer at Crisil Ratings.

Wealth managers estimate the size of the MLD market to be around Rs 70,000 crore. “Both volume of issuance and number of issuers have increased this year. Now, after these tax proposals, it will come down,” he said. Crisil rates a wide swathe of MLDs and guides in the valuation of these instruments.

NBFCs at crossroads

To be sure, the size of the MLD market is miniscule when juxtaposed with the overall corporate bond market. MLD issuances are not even 1 percent of the total corporate bond issuance in a year.

NBFCs dominate as issuers in the bond market and most of them are top-rated entities. Rising bond yields and bank loan rates prompted low-rated NBFCs to raise money through MLDs, a reason why issuance volume has surged in the current year.

“NBFCs could save up to 2-3 percentage points in their borrowing cost through MLDs. A normal bond yield for AA or below rated NBFC is quite steep around 12 percent or more,” said a wealth manager requesting anonymity.

Some NBFCs that have issued MLDs in recent months are Ambit Finvest Pvt Ltd, Edelweiss Alternative Asset Advisors Ltd, IIFL Wealth Finance Ltd, and Incred Financial Services Ltd.

Sitaraman of Crisil pointed out that most MLDs rated by the company have performed well in terms of giving returns to investors. “The MLDs that we rate are principal-protected products. So the investor’s principal is intact and only the returns get affected by the movements in the benchmarks they are linked to. Most of these MLDs give steady returns,” he said.

Kaul from TrustPlutus believes that the liquidity of NBFCs would be affected as a key source of funding is now unavailable. “Yes, there was tax arbitrage but this should also be seen as a source of liquidity for NBFCs,” he said.

Kaul added that even if STCG is applicable to all MLDs in force, there could be calls for early redemption or heavy selling of MLDs. “This will impact the ALM (asset-liability management) of NBFCs. Also, HNIs who are willing to take riskier bets now have no avenue and mutual funds have long stopped taking risk,” he added.

The response to the budget’s tax proposals in the corporate bond market is mixed. While fund managers and bond arrangers believe that an unfair tax arbitrage is behind the rise of MLDs, wealth managers counter this by highlighting that returns compensated investors adequately. Indeed, rating agencies have not seen deterioration in the performance of these debentures.

The upshot is that capital gains tax regime is complicated with asset classes treated differently. Products that encompass the characteristics of multiple asset classes make tax applicability challenging.