Should you invest in Market Linked Debentures (MLDs) ?

Few start-ups are offering a debt investment product that ticks all boxes in terms of returns, efficient taxation and ticket size. Of course, there is much interest among retails investors about this product called as Market linked Debentures. Let’s take a look at the product and try to understand what this means for retail investors like you and whether you should consider investing in this.

What are Market Linked Debentures(MLD)?

Market Linked Debentures are debentures where the pay-off is not defined as in a regular coupon-bearing debenture, but linked to the movement in another security or index such as BSE Sensex or NSE Nifty 50 or 10-year government security (G-sec) yield. 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%. Market-Linked Investments may provide full or partial market downside protection and/or enhanced return potential.

Also read : Market Outlook for Sep 2021

How does a Market Linked Debenture (MLD) work?

A MLD is linked to some underlying financial security like a stock market index such as Nifty or a 10-year government security paper. As there is no income to be had during its tenure, the gain from a MLD is ascertained at the time of maturity, depending on how its underlying asset has moved.

While the issuer is free to choose the security with which payoff for investors is linked, the underlying index is mostly one that it widely traded and not easy to manipulate like Sensex, Nifty, Bank Nifty, Gold or 10 year Government Bond yield.

MLD are of two types – principle protected and non-principle protected. They are issued for a period of 13 months to 60 months and generally come with a ticket size of Rs 25 lakh and more. Unlike a bond that pays a fixed interest either monthly, quarterly, half yearly or annually, MLDs do not pay any regular income. Investor’ income from an MLD comes only at maturity.

For example, if an investor has bought an MLD which is linked to movement in Sensex with a promise to pay 70% movement (participation, as it is termed) in Sensex, then at the time of maturity if the Sensex has moved 50% (point to point), then the investor takes home his principle plus 35% (70% of 50%) return.

Here, at the maturity, investors would see a payoff equal to 135% of principal that they have invested. The Sensex may have actually moved up or down in the interim, but it’s the final position of the index at the time of MLD’s maturity that is considered to ascertain how much money it pays the investor at maturity.

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Risks associated with MLDs

  • Credit Quality

Even though it might be linked to an equity market index, MLD is essentially a debt instrument and hence like all other debt instruments comes with a credit rating. The credit rating is given for the firm that issues MLD, thus participation rate is kept high to entice the customers, if a MLD is issued by a firm with low credit rating.

This means that ability of the issuer to repay plays a huge role here. Investors may suffer a capital loss in case the issuer fails to repay on the obligation.

  • Fulfillment of underlying conditions

The gains from MLDs depend on certain market conditions being fulfilled. In this case investors need to predict reasonably accurately the probability of those conditions being fulfilled.

Also read: Real-estate-investment-trusts

What is the Taxation Impact due to MLD?

Taxation of this instrument is efficient. These are listed on the exchanges and capital gains from listed debentures, after a holding period of more than one year, are taxable at 10 per cent (plus surcharge and cess). There are non-listed MLDs also, but those are not as tax efficient. The MLD has to be sold in a secondary market deal just before maturity. As there is no coupon flow in between your investment date and sell-off in the secondary market, your returns are capital gains from the secondary market deal.

Pros and Cons of MLD

  1. Higher rate of interest as compared to FDs
  2. Efficient taxation
  3. Principal protection feature are the Pros of MLD’s.

The Cons are :

  1. While these products seem like a decent alternative to regular fixed income products, risks in such products are not properly conveyed to the investors. Credit quality of the issuer assumes great importance in this case, there may be no third party source available to check the credit quality of the entity issuing MLD.
  2. Investors need to understand and get right the quantum of move in the underlying index; if the call goes wrong they may be in for disappointment.

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What should the customer do with MLD?

To sum it up, this is essentially a niche product that was hitherto offered to HNI clients who understand the nuances of such complex products. In making them easily available to retail clients at the click of a button, the risks in these products are severely underplayed. Retails clients who go simply by the stated high rate of interest and efficient taxation of this product may be unwittingly taking on risks that are not they are not game for.

Disclaimer:

This article should not be construed as an investment advise, please consult your Investment Adviser before making any sound investment decision. If you do not have one visit mymoneysage.in now

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