Bonds vs Market-Linked Debentures
With increasing awareness about investment instruments such as bonds and MLDs (Market-Linked Debentures), people are diversifying their portfolio. These instruments are allowing investors to get higher returns without taking on high market risks that could result in losses.
When deciding between bonds vs Market-Linked Debentures, it is important to understand how they work and their differences to select a more appropriate investment option. In the following sections, we will focus on the basic characteristics of these two popular investment options.
What Are Bonds?
A bond is defined as a debt instrument issued by a corporation or a government body to raise funds from investors (bondholders). Bond holders receive the principal back when the bonds mature. They also receive periodic interest payments. Coupon is a term used to denote the interest rates of bonds.
Bonds are relatively safer fixed-income debt securities as compared to equity, as the returns are fixed and not affected by the market fluctuations. As per the bond contract, the issuer company repays the principal amount along with a predetermined coupon payments at fixed intervals, annually, semi-annually or monthly. Bonds also carry a fixed maturity date, within which the issuer must make payments.
Though bonds and stocks are capital market securities, there are some notable differences between them. While stockholders have equity stakes in a company, bondholders have creditors’ stakes. This indicates that while stockholders share the status of company owners, bondholders are the lender of a company.
High rated bonds issued by the Government of India, and by large and established corporations in India are the most popular investment options for risk-averse investors.
Pros and Cons of investing in Bonds
Listed below are the benefits and limitations of investing in bonds:
- They are relatively safe and secure investment options.
- Bonds offer fixed returns, which can be ideal for diversifying your investment portfolio.
- They provide relatively higher liquidity among debt instruments.
- Compared to stocks, bonds are much less volatile.
- Bond prices are inversely proportional to interest rates of the market. Hence, the total value of your bond portfolio may suffer from rising interest rates.
- Investments in bonds tend to generate lower returns than equities in the long run.
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What Are Market-Linked Debentures?
Market-Linked Debentures are structured debt instruments where the movements in the underlying index determine their returns. Underlying index, could be equity indexes like NSE Nifty, Sensex, government securities, etc.
MLDs are primarily of two types—principal-protected MLD and non-principal-protected MLD. Principal-protected MLDs are the most common MLDs, and they have a capital protection feature, i.e. investors will receive their initial investment even in a market downturn. However, they will not make any profits. In the case of positive market movements, MLDs will provide returns based on the performance of their underlying index. In India, the issuance of only principal-protected MLDs is allowed as per SEBI regulations. However, even in principal-protected MLDs, the payouts are subject to the credit risk of the Issuer company.
On the other hand, non-principal-protected MLDs do not offer the capital protection feature, which increases the risks. However, these MLDs also carry the potential to generate higher returns.
Pros and Cons of investing in MLDs
Let us take a look at the benefits and limitations of investing in MLDs:
- In the case of listed MLDs, in case the holding period is more than 12 months, LTCG at the rate of 10% is applicable. This results in higher post-tax returns when compared to other fixed-income instruments.
- MLDs provide options for diversifying your investment portfolio.
- It provides indirect access to different markets such as equities, government securities and gold.
- You need to have appropriate knowledge about the movements of the underlying index.
- Most MLDs are principal protected, but it is important to assess the ability of the issuer to repay the principal, otherwise, investors might face a loss of capital.
- For MLDs, pay-outs including principal and interest happens at maturity, so for investors looking for regular flow of repayments, MLDs might not be an ideal investment option.
Differences Between Bonds and MLDs
The table below provides a graphical representation of bonds and MLDs:
|Issuer||The Government of India, large corporations and financial institutions issue bonds.||Large corporations with a minimum net worth of ₹100 crores can issue MLDs.|
|Interest Rate||Bonds have a fixed or floating rate of interest.||The coupon rate is linked to the performance of the underlying index of the MLD.|
|Tenure||Bonds are issued for short-term and long-term tenures||Generally, MLDs are issued for a tenure of 1 to 5 years.|
|Taxation||The interest payment made at regular intervals is taxed as per the bondholder’s tax slab.||Since the coupon payouts are linked to a certain market index, the returns are considered capital gains and taxed as LTCG if the investor holds the MLD for more than 12 months in case of listed MLD (36 months in case of unlisted MLD), from the date of his/her purchase|
Market Linked Debentures have the potential to offer higher returns as compared to certain fixed-income securities. However, they are complex instruments that should be carefully evaluated.
Frequently Asked Questions
What are the different types of bonds?
Different types of bonds include fixed-rate bonds, inflation-linked bonds, floating-rate bonds and zero-coupon bonds.
What are the different types of debentures?
Different types of debentures include convertible debentures, non-convertible debentures, partly-convertible debentures, secured debentures, unsecured debentures, redeemable debentures, non-redeemable debentures.
How safe are MLDs?
SEBI (Securities Exchange Board of India) regulates Market-Linked Debentures, which fall under the classification of debt instruments. In India, the issuance of only principal-protected MLDs is allowed as per SEBI regulations, so they are considered safe and secure investment options.
What are convertible bonds?
A convertible bond is a fixed-income financial instrument that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder.