Imagine if a bank told you that their fixed deposits will pay based on the weather. If it’s sunny on your due date, you’ll get 8%. If it’s cloudy, you get 6%. You are going to bet on the weather for a different return. In fact, that’s what a Market Linked Debenture (MLD) is, except they don’t link it to the weather; they link it to something that is in the market, such as a government bond or an index. We cover them in this post.
Market Linked Debentures (MLDs) are sold to individuals and are gaining more credibility lately. The idea of a market-linked bond is to have a “bond” that gives you income that is tied to a particular market index. It can be significantly risky or not, depending on how this works.
They offer a big tax advantage. Market-linked bonds are only taxed at 10% if they are sold on the market after one year. Not three years like mutual funds with debt; therefore, debt products can be structured to: ensure great after-tax returns if they are market bound!
If you can get an 8% market-linked bond, it’s actually 7.2% for you if you sell it after one year. An 8% fixed deposit is actually 5.6% after tax for a person in the 30% tax bracket. The MLD is considerably more attractive! But why and how do Market Linked Debentures (MLDs) work?
An example, please, of a Principal Protected MLD
Let’s take a simple example:
- ABC company issues a MLD that pays out a coupon of 8% per year, maturing in 14 months.
- But that 8% is only given on condition: if the government bond due 2030 does not fall 25% in price (no yield), measured exactly on the 13th month.
- If the government bond really fell that way, you only get your principal back (no interest)
This is a principally protected MLD, where you get at least your principal back, and a “coupon” linked to a market index or instrument. In this case, you will earn 8% per year unless the government bond falls in price by 1/4.
The issuer of this MLD may borrow from you at 8% and probably won’t get a better rate anywhere else for the same amount of time. So basically this publisher also benefits.
You will get a great after-tax return as 8% is really only 7.2% (since the tax is 10% if held for more than a year). But there is a warning: the bond must be sold in the market! This means that if you let it “mature”, the issuer will give you the coupon as interest, which is taxable, just like a fixed deposit. Horrible.
So your next question is: Deepak, what if i can’t sell it on the market? What if there are no buyers? Why should I do this?
The sale can be accomplished in many ways: a repurchase by the issuers, a repurchase by an entity associated with the issuer, or a commercial bank associated with it. They will assure you that they will buy it back from you before the expiration date, in the latter two cases possibly a few days earlier. This ensures that you get the return with the tax benefit. They probably won’t give it to you in writing, so it’s kind of a wink-wink-nod-nod. Also buybacks are not easy to structure in advance (and need approval from all lenders)
A standard mechanism is to make the issuer pay a “redemption premium”, basically a buyback. However, there is a risk that the Income Tax Department will treat any payment from the issuer as interest (coupon) rather than capital gains, negating any tax benefits. The safest bet is to sell the bond in the market before maturity.
(more examples later)
What about convenient linked bonds?
Some bonds tell you something like this: if the Nifty goes up, you make the Niftys back. If it falls, you don’t lose your principal. Such concepts are often packaged as MLDs and sold to retail investors who want to reduce their risk of a market decline, but participate in an eventual rise.
Such products are not difficult to build. In fact, we build one every year at Capitalmin Premium: check out the No-Downside Nifty strategy.
Doing it yourself is easy, but it’s not tax-efficient as 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 profit!
Who can buy MLDs?
MLDs are like bonds and anyone can buy them, but they are usually sold to high net worth investors. In fact, many MLDs are structured in such a way that returns to HNIs are tax efficient. Market Linked Debentures have a face value of Rs. 10 lakh per MLD (usually), so they usually make sense for the well-heeled.
There are many uses of MLDs:
- In an overheated market, you can get the advantage of the market, but not the disadvantage. (like our Handy strategy without drawbacks.)
- You can get a tax-efficient return on a debt instrument by investing in a publicly traded bond with only 10% tax on profits instead of a regular interest-paying instrument.
- MLDs are useful for family offices or HNIs, who must have proper after-tax returns. The lower tax rate is therefore attractive.
- An MLD can also give you access to other markets.
Who Shouldn’t Buy MLDs? Most institutions, such as mutual funds, insurers or pension funds, will find this unappealing because they do not pay income tax. They would be looking at higher pre-tax returns, and in all likelihood it’s because a company can’t raise money from such institutions that they go the MLD route.
Also, do not buy if you are unsure of the underlying issuer’s risk.
Where do you buy MLDs? These are usually sold by distributors or investment banks, who receive commissions from such products (about 1% to 2% as entry tax). MLDs are limited to a minimum (and multiple of) Rs. 10 lakh per MLD and are usually spent through an offline process. You can buy them on an exchange, but they are impossibly illiquid and hardly any such instruments are traded.
Wait, where’s the risk?
There are no free lunches. Why would anyone just offer you such a great after-tax return? Because they are nice? If you really believe that, I suggest you take a cold shower first, because everyone in the financial world wants to make money.
The risks are:
- You’re lending to a company that probably can’t get a low-interest loan anywhere else, so they’re offering you a higher interest rate that’s super tax-efficient. This could cause the company to default, so you should: CREDIT RISK.
- Even in a Nifty Linked Debenture, the idea that your downside is “guaranteed” is based on the NBFC (which guarantees the MLD). However, this carries a risk of default. Again, CREDIT RISK.
- You can not leave in the “middle” – the guarantees apply only if you stay until the end. So there is liquidity risk.
- Some commissions can affect the MLD’s revenue or even key protections. If you pay 2% to buy such a product that gives you 8%, your final return drops by 2% (spread over the number of years of the investment)
- There is also the risk that the tax authorities will change the tax rules later, causing the tax structure to change in the event of such exits.
Complexity risk also exists. The products can be simple – the example above was. There are examples of MLDs like this: If Nifty rises less than 50% from the average of the three initial “fixing” dates (one month apart), you get the Nifty return * 1.1; If it’s over 50%, you’ll get a fixed 8% return for three years (non-compound), but if Nifty falls from its original fixation level, you’ll get no return, just your principal. Oh, and there’s one final finding, which is again the average of the last three months of the Nifty, to get to what such a fall means.
To decode such things, you need a calculator and no sharp objects nearby that could make you hurt yourself, as the stinging is known to be less painful.
Therefore, the whole concept will be based on trust, and where there is trust there is a risk that that trust will be broken.
A REAL example?
L&T Infra Finance issued an MLD in 2020, and you can click here to read the prospectus. The terms are a bond that pays 7% per annum for a 21-month MLD if a particular government bond does not fall in price by 25%.
Here is a Kotak Mahindra Prime (an NBFC, owned by Kotak bank) issuance of a three-year MLD linked to the performance of the Nifty:
You can see why stabbing yourself is easier. The product says you invest for three years. The maximum you can get is 65% (in total over three years, which means an upper limit of about 21% per year). At each intermediate level, we have a “lock-in” and a different set of observation data. In effect, you protect the downside for three years (meaning that if Nifty were lower than its current level three years from now, you won’t lose money, but you won’t get any interest either).
This particular product worked quite well, but yes, even the Nifty gave about 70% at the time. Your return would be capped at 65% – if the Nifty were above 65%, you wouldn’t earn any of that extra.
But if the math is exciting and the slight difference sounds like it was worth taking the credit risk on Kotak Mahindra Prime in 2011, this product would have been a good choice for you. If you’re wondering at this point why anyone would ever buy something like this, MLDs aren’t for you.
Who shouldn’t buy?
People who want “security” without understanding the complexity and risks of this tool should avoid it. These are complex and depend on one thing: the issuer will not default when asked to pay. Only the wealthy have the ability to drag issuers through the courts.
It makes no sense for tax-exempt entities such as mutual funds or insurers.
People who may need to withdraw early are not good for Market Linked Debentures. They require a lock-in until near maturity.
In general, this is only a useful product for those who understand the complexity, use the lower tax mechanism and significantly increase the after-tax returns. At a time when deposit rates are low, an MLD may be a better way to participate. Or, when markets appear to be going down, a principal-backed bond that gives you the handy advantage, but not the disadvantage, may be a good bet. But make sure you know what you’re buying!