- Wealth PMS (50L+)
Imagine that a bank told you their fixed deposits will pay based on the weather. If it’s sunny on your maturity date, you get 8%. If it’s cloudy, you get 6%. You’re going to bet on the weather for a different return. Effectively, that’s what a Market Linked Debenture (MLD) is, except they don’t link it to the weather; they link it to something that’s in the market – like a government bond or an index. We cover them in this post.
Market Linked Debentures (MLDs) are being sold to individuals and gaining more credence recently. The idea of a market-linked debenture is to have a “bond” that gives you income linked to a certain market index. It can either be substantially risky or not, depending on how this works.
They offer a major tax advantage. Market linked debentures are taxed only at 10% if sold in the market after one year. Not three years like debt mutual funds; therefore, debt products can be structured to provide great post-tax returns if they are Market Linked! Effectively, if you can get an 8% market-linked debenture, then it’s actually 7.2% to you if you sell it after a year. A fixed deposit at 8% is actually 5.6% post-tax for a person in the 30% tax bracket. The MLD is significantly more attractive!
Note: Budget 2023 has removed the tax advantages of MLDs and made them the equivalent of short term debt. So the earlier paragraphs on tax no longer apply. (Read our post)
But why and how do Market Linked Debentures (MLDs) work?
Let’s take a simple example:
This is a principal-protected MLD, where you will get your principal back at the very least, and a “coupon” which is linked to a market index or instrument. In this case, you make 8% per year, unless the Government bond falls by 1/4th in price.
The issuer of this MLD is getting to borrow from you at 8% and is probably not getting a better interest rate borrowing anywhere else for the same time. So in effect, this issuer also benefits.
You get a great post-tax return since 8% is actually only 7.2% (considering the tax is 10% if held for over a year). But there’s a caveat: the bond has to be sold in the market! Meaning, if you let it “mature”, the issuer will give you the coupon as interest, which is taxable, just like a fixed deposit. Horrible.
Note: Tax changes in 2023 make the tax advantage nil.
So your next question is: Deepak, what if I can’t sell it in the market? What if there are no buyers? Why would I do this?
The selling can be achieved in many ways: a buyback by the issuers, a repurchase by an entity linked to the issuer, or a merchant bank associated with it. They will assure you that they will buy it back from you before the maturity date, possibly a few days earlier in the latter two cases. That ensures you get the return with the tax advantage. They probably won’t give it to you in writing, so it’s a bit of a wink-wink-nod-nod kind of deal. Buybacks, too, cannot easily be structured in advance (and needs approval from all lenders)
One standard mechanism is to have the issuer pay a “redemption premium”, effectively a buy-back. However, there is the risk that the Income Tax department considers any payment from the issuer to be interest (coupon) rather than capital gains, negating the tax benefits. The safest bet is to sell the bond in the market before maturity.
(More examples later)
Some debentures tell you something like this: If the Nifty goes up, you make the Nifty’s return. If it falls, you do not lose your principal. Such concepts are often packaged as MLDs and sold to retail investors who want to reduce their risk of a market fall but want to participate in any upside.
Such products are not difficult to build. In fact, we build one every year at Capitalmind Premium: check out the No-Downside Nifty Strategy.
Doing it yourself is easy, but it’s not tax-efficient since it generates taxable business income (at 30%+ on the higher brackets). However, an NBFC can do it as a Market Linked Debenture, and suddenly there is only 10% tax on the gains!
MLDs are just like bonds, and anyone can buy them, but they are usually sold to High Net Worth investors. In fact, many MLDs are structured for tax-efficiency of returns to HNIs. Market Linked Debentures come at a face value of Rs. 10 lakh per MLD (usually), so they tend to make sense for the well-heeled.
There are many applications of MLDs:
Who should not buy MLDs? Most institutions, such as mutual funds, insurers, or pension funds, will find this unattractive since they don’t pay income tax. They would look at higher pre-tax yields, and in all likelihood, it is because a company cannot raise money from such institutions that they go down the MLD route.
Also, don’t buy if you aren’t sure of the risk of the underlying issuer.
Where do you buy MLDs? These are typically sold by distributors or investment banks, who get commissions from such products (around 1% to 2% as an entry load). MLDs are restricted to a minimum (and multiple of) Rs. 10 lakh per MLD and are usually issued through an offline process. You can buy them on an exchange, but they are impossibly illiquid, and hardly any such instruments trade.
There are no free lunches. Why would anyone offer such great post-tax returns to you just like that? Because they’re nice? If you truly believe that, I suggest you get a cold shower first because everyone in finance wants to make money.
The risks are:
Complexity risk exists, too. The products can be simple – the example above was. There are examples of MLDs like this: If Nifty goes up less than 50% from the average of the three initial “fixing” dates (a month apart from each other), then you get the Nifty return * 1.1; If more than 50% then you get flat 8% return for three years (non-compounded) but if Nifty falls from the initial fixing level, then you get no return, just your principal back. Oh, and there’s a final fixing, which is again the average of the last three months of the Nifty, to arrive at what such a fall means.
To decode such things, you need a calculator and no sharp objects nearby that allow you to stab yourself badly because it’s well known that the stabbing is less painful.
Therefore, the entire concept will be based on trust, and where there is trust, there is the risk of that trust-breaking down.
L&T Infra Finance issued an MLD in 2020, and you can click here to read the prospectus. The conditions are a debenture that pays 7% per annum for a 21 month MLD if a certain Government bond does not fall 25% in price.
Here’s a Kotak Mahindra Prime (an NBFC, owned by Kotak bank) issuing an MLD for three years linked to the Nifty’s performance:
You can see why stabbing yourself is easier. The product says you invest for three years. The max you can get is 65% (in three years, in total, meaning an upper limit of about 21% per year). At each intermediate level, we have a “lock-in” and a different set of observation dates. Effectively you protect the downside for three years (meaning if Nifty were to be lower than the current level in three years, you don’t lose any money, but you get no interest either.)
This particular product worked out quite well, but hey, even the Nifty gave about 70% in that time. Your return would be limited to 65% – if the Nifty went any higher than 65%, you don’t make any of that extra.
But if the math is exciting and the small difference sounds like it was worth your while to take the credit risk on Kotak Mahindra Prime in 2011, this product would have been a good fit for you. If at this time, you’re wondering why anyone would ever buy something like this, MLDs are not for you.
People who want “safety” without understanding the complexity and risk of this instrument should avoid them. These are complex and rely on one thing: the issuer will not default when asked to pay up. Only the well-heeled have the ability to drag issuers through courts.
It’s of no use to tax-free entities such as mutual funds or insurers.
People who might need to withdraw early are not good for Market Linked Debentures. They require a lock-in until near-maturity.
Overall, this is a useful product only for those who understand the complexity, use the lower-tax mechanism, and substantially increase post-tax returns. At a time when deposit rates are lousy, an MLD may be a better way to participate. Or, when markets are looking like they will fall, a principal-protected debenture that gives you the Nifty upside but not the downside may be a good bet. But make sure you know what you’re buying!
Note: the tax advantage is gone (post), so an MLD had better give you significantly higher pre-tax yields to be useful.