Market-Linked Debentures (MLDs) had become increasingly popular with issuers and individual investors over the past two years.

Investors chose market-linked debentures for efficient tax returns as the interest rates were low until mid-2022.

These MLDs offered returns of 8-10% during 2021 and in the first half of 2022, based on the underlying security's performance.

According to NSE electronic book mechanism issuance data, close to ₹48.69 billion were raised through listed Principal-Protected MLDs in this period.

The Government of India has effectively put a death knell to the issuance of MLDs, following the Finance Minister's announcement in the Union Budget 2023 that income from MLDs will be taxed as short-term capital gain effective from Apr 1, 2023, regardless of holding period.

Market-linked debentures currently are taxed at 10% without indexation as long-term capital gains.

High-net-worth individuals and family offices, which typically fall in the highest income tax bracket, will no longer have the tax arbitrage from the income of such debentures. Hence, the appetite for such issuance may wane this year.

What Exactly Are MLDs?

Market-Linked Debentures are structured, fixed-income securities that offer variable coupon payments based on the performance of underlying market securities or indices linked with them.

The offer document of these MLDs informs the holder during the time of issue regarding the specifics of such underlying securities, including performance requirements.

The MLDs are generally linked to benchmark government securities, MIBOR, inflation rate, gold index, Nifty-50, Sensex, and other such market reference parameters.

The coupon is set at the time MLDs are issued but is paid at maturity as a bullet payment and is dependent on how well the benchmarks connected to the debentures perform.

There are two types of market-linked debentures:

a) Principal-protected market-linked debentures.

b) Non-principal protected market-linked debentures. These are considered debt securities under regulation 2(k) of SEBI NCS Regulations.

Principal-protected MLDs offer to pay back the principal amount to an investor at the maturity of the debt instrument with or without coupon payment.

These debentures may be listed or non-listed securities and generally have a tenure of 1-year to 5-year. The face value of principal protected MLDs may range from ₹100,000 to ₹2.5 million.

Examples:

1) Debenture Linked with Government Securities: XYZ company issues PPMLDs for 36-month maturity, at a face value of each debenture worth ₹1 million, and are linked with 10-year benchmark government security. If the price of the benchmark G-Sec falls by 25% at the time of the XYZ company's market-linked debenture maturity, then XYZ company will pay an 8% coupon, or if the price rises, no coupon payment is made at the maturity.

2) Debenture Linked with Stock Market Index: XYZ company issues PPMLDs for 18-month maturity with a face value of each debenture worth ₹1 million linked to Nifty-50 performance. If the Nifty-50 index rises at the end of 18 months, then the Nifty-50 percentage returns are offered along with the principal amount. In case the index decline, only the principal amount is paid to the investors.

Issuer Base & MLD Valuation

The issuer base for these securities in India is typically non-banking finance companies (NBFCs) and a few infrastructure and real estate firms.

These companies raise money through PPMLDs to meet medium-term lending, funding projects, or investment requirements and tap the MLDs market when banking loans are unavailable.

Companies that have raised funds through MLDs so far include Reliance Capital, India Infoline Finance, Axis Finance, L&T Infrastructure, INOX Green Energy, Kotak Mahindra Prime, and Edel Land.

The main advantages that issuers receive from launching MLDs are:

i) No fixed, regular payment of coupons during the term of the MLDs.

ii) Exemption from the electronic book mechanism for the issuance of securities on a private placement basis.

SEBI allows companies with a minimum net worth of ₹1 billion to issue such debentures.

Since PPMLDs are different in their nature and risk-return relationship, SEBI has mandated a compulsory valuation of the structures by AMFI-appointed agencies such as CRISIL, CARE, and other credit ratings firms.

Credit rating agencies determine valuation methods and show valuations periodically on their websites as per SEBI guidelines.

As defined by CRISIL, MLDs are a combination of derivative instruments and fixed-income instruments.

CRISIL uses a sum-of-the-parts method to value MLDs. A typical MLD has two parts:

● The fixed income component that protects the principal invested in the MLDs.

● The derivative component which provides returns linked to the market.

The valuation of the bonds portion is done based on discounting method, while the derivative component is based on Monte Carlo Simulation techniques.

Investor Base

Major participants in subscribing to these MLDs, consist of high net-worth individuals (HNIs), family offices, and retail investors to avail taxation benefits.

These MLDs were designed to be tax efficient as the income tax regulations state that 10% of the tax is applicable on long-term capital gains for listed bonds held for more than a year. So, HNIs and family offices that typically fall in the 30% income tax bracket can avail of the benefit by investing in these listed MLDs.

Institutional investors such as mutual funds, insurance, and pension funds look at the larger pre-tax rates and returns. They would generally avoid investing in market-linked debentures. Also, a major reason for the issuers to tap MLDs is the lack of funding through financial institutions.

Risks Associated with MLDs

There are inherent risks associated with investments in such structured debt instruments. Investors may need to be cautious and aware of the associated risks.

Credit risk is one of the major risk factors in MLDs in case a company defaults or becomes insolvent. An investor may lose not only the interest payment but also the principal component.

Liquidity risk is high for such MLDs as there is little or no liquidity in the secondary market.

Regulatory risk is something that an investor may consider in the event of changes in taxation rules and laws.

MLDs are highly structured and complex debt instruments and form a risk to investors if they invest without understanding the terms of issuance and bullet coupon payment.