A Comprehensive Guide To Market Linked Debentures

What Are Market Linked Debentures

Market Linked Debentures (MLDs) are a type of financial investment instrument linked to the movement of an underlying index or asset such as Nifty 50, Sensex, Gold Index, 10-year G-Sec yields, etc. They combine the characteristics of traditional vanilla debt securities with exchange-traded derivatives. These investments offer investors the opportunity to gain exposure to the stock market without taking on too much risk. By investing in MLDs, investors can benefit from potential gains while protecting their capital from losses due to market volatility.

In this comprehensive guide, we will delve into the features, benefits, and risks associated with MLDs, helping you navigate this investment option with confidence and meet your financial goals.

How Do Market Linked Debentures Work?

MLDs are typically issued for 13 to 60 months (as per CARE Ratings’ Article on MLDs) by entities having a net worth of at least INR 100 crores¹. The return from an MLDs is determined at maturity, based on the performance of its underlying security. As opposed to regular coupon pay-offs as in the case of plain vanilla debt securities, the returns are only paid when they mature. To illustrate this concept, let's consider the below example:

ABC Limited has introduced MLDs with a maturity period of 2 years. The MLDs offer a return of 12% XIRR (Extended Internal Rate of Return), subject to the condition that the value of the Gold Index at the end of the 2-year term does not drop below 20% of its value at the time of MLDs issuance. To illustrate, let us assume the Gold Index at the MLDs issuance was INR 60,000. If, at the MLDs maturity (2 years from the issuance date), the Gold Index is equal to or greater than INR 48,000, the issuing company will pay the bondholder the principal amount along with interest calculated at a rate of 12% XIRR for the 2-year duration.

However, in an unfavourable scenario where Gold Index at the maturity date falls below INR 48,000, the company will reimburse the holder of the MLDs only the principal amount without any interest.

Categories Of Market Linked Debentures

There are two broad categories of MLDs:

1. Principal-protected MLDs – where there is protection of principal amount thus protecting the MLDs holder from the risk of any downside in the market.
2. Non-principal protected MLDs – the principal amount may not be paid by the issuer in case of adverse performance of the underlying asset or index. 

SEBI Operational Circular (SEBI/HO/DDHS/P/CIR/2021/613 dated 19 Aug 2021) allows the issue of principal protected MLDs only in India². These regulations also stipulate that even in principal-protected MLDs, the payouts are contingent upon the credit risk associated with the issuer company.

Credit Rating Of Market Linked Debentures

The credit rating of MLDs plays a crucial role in assessing the creditworthiness and risk associated with these investment instruments. Credit rating agencies such as S&P, Moody's, and Fitch are well-known agencies that assign credit ratings to various financial instruments, including MLDs. They evaluate the issuer's ability to meet its financial obligations and assign ratings based on their assessment of credit risk. 

MLDs can have varying credit ratings, ranging from 'AAA' to 'AA,' and even 'A' or 'BBB,' or ‘C’ or ‘D’ (as per one of SEBI registered Credit Rating Agency’s criteria) indicating the borrower's level of creditworthiness, with 'BBB' reflecting moderate creditworthiness³. 

Difference Between Bonds And MLDs

Advantages Of Investing In Market Linked Debentures

MLDs are financial instruments that provide investors with the security of a fixed income but also the potential for higher returns than traditional investments. Some of the key benefits are:

• Diversification: MLDs provide exposure to a variety of underlying assets or indices, enabling investors to diversify their investment portfolios and mitigate risk.
• Potential for Higher Returns: By linking the performance of MLDs to underlying assets or indices, investors have the opportunity to earn higher returns if the market performs favorably.
• Fixed Income Component: MLDs offer a fixed income component at maturity, ensuring investors receive predictable cash flows, even in volatile markets.
• Tailored Risk-Return Profile: MLDs can be structured to suit different risk appetites and investment objectives. Investors can choose their desired participation rate and protection barrier, allowing customization of risk exposure.
• Hybrid Structure: MLDs offer investors the opportunity to gain exposure to the stock market without taking on too much risk. Investors can benefit from potential gains while also protecting their capital from losses due to market volatility.

Risks Associated With Investing In Market Linked Debentures

It is important to understand the risks associated with investing in MLDs. Consider the following risks before investing in this instrument:

• Market Risk: MLDs are subject to market fluctuations. If the underlying asset/index performs poorly, investors may not receive the expected returns.
• Credit Risk: MLDs carry the risk of default by the issuer. Assess the creditworthiness and financial strength of the issuer to evaluate the likelihood of default.
• Liquidity Risk: MLDs may have limited liquidity, making it challenging to sell before maturity. Investors should carefully consider their investment horizon and liquidity needs.
• Complex Structuring: MLDs can have intricate structures. It is crucial to thoroughly understand the terms and conditions and payout calculations before investing to avoid confusion or unexpected outcomes.

Taxation On Market Linked Debentures

The Union Budget of 2023 has repealed the usual taxation guidelines for MLDs. From FY-2023, gains earned from the redemption of MLDs will be short-term capital gains (STCG) and taxed at the applicable investor’s tax slab instead of being long-term capital gain (LTCG) and taxed at the rate of 10% as earlier⁴.

Conclusion 

Market Linked Debentures provide investors with the opportunity to diversify their portfolios while potentially earning returns linked to the performance of underlying assets or indices. Understanding the features, benefits, and risks associated with MLDs is crucial for making informed investment decisions. By carefully evaluating the underlying asset/index, participation rate, protection barrier, issuer creditworthiness, and personal risk tolerance, investors can navigate the world of market linked debentures and potentially benefit from their unique characteristics. 

References:

1. Care Ratings <https://tinyurl.com/yjw4a4mc>
2. Securities and Exchange Board of India (SEBI) <https://tinyurl.com/45wt2f3r>
3. Brickwork Ratings <https://tinyurl.com/565p4n64>
4. The Times of India <https://tinyurl.com/4w4vawak>

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Disclaimer: This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip Invest Technologies Private Limited ("Grip", formerly known as Grip Invest Advisors Private Limited) is not registered with SEBI in any capacity and does not advise, encourage, or discourage its users to invest or not invest in any securities. Grip is solely an execution-only platform and does not guarantee or assure any return on investments made by you in any opportunities sourced by Grip and accepts no liability for consequences of any actions taken based on the information provided. Your investment is solely based on your judgement. Investments in debt securities are subject to risks. Read all the offer-related documents carefully.