What are the types of Market Linked Debentures
People are always on the lookout for investment options that generate higher yields but without the risk of major losses. MLDs (Market-Linked Debentures) are just the perfect option to do so.
These fixed-income debt instruments have been structured to combine the features of bonds and stocks. Returns from MLDs are not fixed and depend upon the market movements of their underlying index or securities, and investors receive their payments at maturity.
In this blog, we will focus on the types of Market Linked Debentures and their benefits and risks.
What Are the Types of MLDs?
There are two main types of market-linked debentures. Given below are their details:
Principal-protected MLDs provide capital protection to investors, i.e. if the market falls drastically, investors will not receive any return but will receive their principal amount back. But, if market movements are positive, investors will receive returns in proportion to their investments and the value of the underlying securities. The capital protection feature of these MLDs has made them a popular investment instrument. 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.
Non-Principal Protected MLDs
These are market-linked debentures which do not provide the capital protection feature, i.e. investors will not get back their principal amount if the market falls drastically. The risks associated with non-principal-protected MLDs are significantly higher than principal-protected MLDs. However, their return potential is high as well.
Example of Market-Linked Debenture
With the help of the following example, we will be able to understand principal-protected MLDs better:
A company issues an MLD with a coupon rate of 9% per year and a maturity period of 15 months. However, there is a condition attached to underlying the coupon payment. The investor will receive the coupon only if the MLD’s underlying government security does not fall more than 25% in price.
If the government security price falls more than 25%, the investor will receive only his principal amount back and not the coupon payment.
Benefits of Market-Linked Debentures
Discussed below are the advantages of MLDs:
Listed below are the advantages of MLDs for issuers:
- Most debentures require issuers to pay monthly or half-yearly interest through a fixed coupon rate. However, MLDs provide their issuers with the benefit and convenience of servicing debt obligations with a one-time payment that is at maturity.
- Non-Operative Financial Holding Companies or NBFCs (Non-Banking Financial Companies) benefit from MLDs in numerous ways. Apart from diversifying their source of funds as HNIs, these financial entities also get an opportunity to raise funds as 5 ISINs (International Securities Identification Numbers) maturing per financial year is allowed for structured debt securities and market linked debt securities, over and above plain vanilla debt securities.
Given below are the benefits of MLDs for investors:
- They are an ideal investment option for investors wishing to get higher post-tax returns for short investment tenures.
- Compared to equity-linked investment instruments, where there is a possibility of capital loss, principal-protected MLDs offer investors more security.
- MLDs can be carefully structured to fulfil different investment objectives.
- Compared to other investment options, MLDs are tax-efficient. 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.
Risks Associated With MLDs
Discussed below are the risks of investing in market-linked debentures:
MLDs are another source of borrowing for a company. In case the company does not perform well or incurs huge losses, it may not have the capacity to pay off the bondholders, thus resulting in partial or complete capital erosion of the investor.
An investor must do their own analysis by checking the financials and operations of the company to understand its creditworthiness and potential risk of default. Also, to mitigate risk, an investor should also check the rating of the Issuer and invest only in MLDs issued by companies having investment-grade ratings.
MLD issuers make a one-time principal and interest payment only at the maturity So, people who may need to liquidate their investments before the stipulated time frame should not opt for MLDs.
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. If one understands the complexities and risks involved, one can consider investing in MLDs.
Investors should analyse market movements and conditions minutely before investing in MLDs. Though principal-protected MLDs ensure investors receive back their original investment amount, interest payments are based on the market-linked index’s performance. So, in case of a downfall in the market, investors stand the risk of receiving low or no returns.
Essential Things to Consider before Investing in MLDs
Listed below are essential things that investors must consider before investing in MLDs:
- Individuals must assess their risk profile and formulate their investment goals before investing in market-linked debentures.
- Investors need to understand their liquidity requirements. In other words, asking the question—’ would I need the money before the maturity period’—would help to decide on the investment amount.
- An essential thing to consider before investing is assessing the issuer’s ability to repay.
- Checking the terms and conditions of the MLD minutely is of vital importance as the performance of the underlying market index determines the payments of coupons.
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To sum up, there are mainly two types of market-linked debentures —principal-protected and non-principal-protected debentures. While the former assures principal repayment, the latter provides no such assurance though it carries the potential of offering higher returns. Investors must thoroughly assess the issuer’s credit profile and their risk appetite before investing in MLDs.
Frequently Asked Questions
Where can you purchase MLDs?
Generally, MLDs are sold by investment banks or distributors that receive a commission from distributing these financial products (usually 1% to 2% of the entry load). You can buy MLDs from exchanges as well, but the MLD trading market is not highly active.
What are non-convertible debentures?
NCDs (Non-Convertible Debentures) are fixed-income instruments, usually issued by a government or corporate entities, to fulfil the need for capital raises from the market. The NCD issuer promises to pay a fixed coupon rate in exchange of the amount borrowed from an investor, at a fixed interval.
What are the essential factors that investors must assess before investing in MLDs?
Investors must research the issuer’s profile, such as credit rating and history of repayments, before investing in market-linked debentures. Details of the underlying businesses of the issuer, along with its diversification and analysis of crucial financial ratios, should be considered before investing.
How do I sell my MLD?
You can sell off your listed MLDs in the secondary market. There is no coupon flow in between your investment date and sell-off in the secondary market, and your returns are capital gains from the secondary market deal.