Are market-linked debentures worth your money?

A minor portion of the face value of the MLD is linked to equity market returns through call options and the remaining amount is invested in a bond. The former gives the return kicker while the latter is a cushion for minimum returns. In the case of this MLD, the assured return at 6.58 percent comes from the issuer and is lower than the 7 percent annual interest that HDFC Bank is offering on a two-year fixed deposit.

However, equity-linked MLDs are not necessarily comparable to fixed deposits as the objective is upside participation in equity returns with minimum risk.

According to Vijay Kumar Kuppa, chief executive officer, InCred Money, “With Nifty 50 close to all-time highs, we had a lot of client queries on what to do with existing equity allocation. Such a structure allows one to book profits and reinvest with the idea that if the equity market up move continues you get to participate in that, at the same time if the markets correct, your capital is protected. For new investors too, such a structure can provide a low-risk entry to experiencing equity market returns.”

Till December last year, the Securities and Exchange Board of India had mandated a minimum investment of Rs 10 lakh for privately placed debt, which has since been altered to Rs 1 lakh. Kuppa says this change nudged and enabled the thought of taking innovative debt securities to retail investors.

While wealth advisors place MLDs as part of debt allocation, the lure is the possible outsized equity returns. The portion of the principal which is invested in equity index options has the potential to deliver high returns if over the tenure of the MLD, the underlying equity index gains substantially. In the case of InCred’s MLD, the Nifty 50 will have to deliver at least 20 percent to 40 percent return from the time of investment till maturity for investors to make an absolute return of 20 percent to 30 percent over the two-year tenure. “Investors get participation in Nifty 50 returns, with total return over a two-year period floored at 14 percent and with an upside cap of 30 percent,” says Kuppa. This is the total return over a 2-year period.

However, returns from MLDs are taxed at the rate of your marginal rate of income tax, in line with debt taxation. In a rising rate cycle, as a debt investment, without the equity kicker, MLDs are just about delivering fixed deposit-like returns, without the earlier advantage of equity taxation (removed in last year’s Union Budget). Given this payout structure, are MLDs worth your while?

What an MLD payoff looks like

Let’s understand the structure before debating suitability.

Broadly, they come under two umbrellas, principal protected and principal unprotected. Within these there are multiple structures for MLDs in the market, you can pick and choose the one you prefer. InCred’s NCD is principal protected. A principal protected MLD is likely to have a relatively lower risk and hence lower payoff as compared to a principal unprotected MLD.

Sample this: we assume that MLD A is principal protected and the minimum investment is Rs 100 (face value). The market linked component which is responsible for the return kicker and invested in equity index-linked call options is Rs 5 and the debt component, invested in the debt security of the issuer, is worth Rs 95. If the equity market moves below the initial value at the maturity date, you will lose the entire Rs 5 (See graphic).

market linked debentures

In the case of the InCred MLD mentioned above, the debt portion delivers a 20 percent return where Rs 95 becomes Rs 114, during the MLD’s two-year tenure. This works out to a minimum assured 6.58 percent annualised return on capital invested (XIRR as per the MLD information memorandum published on the website).

Let’s assume MLD B is principal unprotected MLD. Here, the equity linked portion that gets invested in index call options may be as high as 20 percent, or Rs 20 of Rs 100. The payoff structure then looks to deliver 50 percent-100 percent or more absolute return in a 3-year period. The caveat here is that if the Nifty 50 falls more than a certain defined level (can be defined for each structure) in those three years, you will start to lose capital. Moreover, the payoff may be such that outsized returns compared to Nifty 50 at maturity are possible only for a limited return range, after which the upside gets capped.

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There can be several permutations for a structure, depending on the proportion invested in the equity call option, the type of derivative exposure, the payoff for clients, the return profile for the issuer for the bond component and the time to maturity. In some cases, the maturity date is a few months before you get the actual payout which can be confusing and you have to wait, despite no gains accruing for that period.

Risks associated with MLDs

Deepak Chhabria, chief executive officer and director, Axiom Financial Services, says, “There is a certain degree of complication in such structures, which distributors must ensure that clients understand. Given that calibrating possible return outcomes and unpacking the risk is not an easy task, such structures are more suitable for very rich investors or ultra-high-net-worth individuals with a few hundred crores of investible surplus.”

Let’s consider a principal-protected MLD with assured return, where you think there is zero risk. In reality, it’s not that simple.

The first thing to consider is default risk on the debt portion in the MLD. The debt portion is essentially a bond issued by a company. If the cash flows and balance sheet risk of the entity turn unfavourable, it can potentially lead to a default and loss of capital, despite the assured return.

“MLDs come with single issuer risk which can be very risky if the credit cycle is not favourable for the issuer,” says Rushabh Desai, founder, of Rupee With Rushabh Investment Services.

There is also market risk. If equity markets fall sharply, you incur losses. Thanks to just a single day’s sharp correction, you could lose out entirely on the upside potential return. In the case of unprotected MLDs, you can lose capital too.

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“This is a digitally promoted MLD, and while we have explained all details on our site, we still get queries given the novelty of the product. Nevertheless, those who understand it are doing it. Along with all the risk and return details given online, we also have a ‘book a call’ nudge on the website for investors to get their queries resolved,” says Kuppa.

Aside from details of InCred’s MLD that you could read up on its website, it’s always best to ask the distributor or advisor selling the product all the relevant questions on risks and payoffs. Both of these can get complicated; higher payoffs come with higher risks and complex structures, especially with principal unprotected MLDs.

According to Desai, “We are not in the business of predicting market levels in such short periods. If the lure is return from equity participation, then it’s better to stick to direct buying in the stock markets via managed products like mutual funds, rather than complicating the asset exposure.”
MLDs are also not always liquid securities despite being listed. Liquidity may be offered in the form of a buyback from the issuer but that will come at an additional cost; for the InCred NCD mentioned above the cost is 2 percent of the amount.

Lastly, the marketing of MLDs may get colourful and information about details is not always available upfront.

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Desai says that while these products are approved by the capital market regulator, there are a lot of permutations which can be risky. “Details of how the structure functions are not completely and freely available to all,” he adds.

MLDs are ideal for ultra-high-net-worth individuals with enough surplus to take on various risks. It also requires the investor to have an outsized view of the upside in the equity market, in the months ahead. If their view matches the issuers’ and the markets are kind, the leverage taken thanks to options can pay off big.

The discussed InCred issue is structured for retail investors, however, understanding the pay-off is important, and while there is the potential for equity-like upside there is also the risk of getting fixed deposit-like post-tax returns.

Ultimately, the upside payoff is a gamble on the market level at a given time, and there is no way to ascertain whether that gamble will pay off.