The Quest for Positive Real Returns
InCred Wealth October 20, 2022
Market Linked Debentures: Who should invest, tax benefits, associated risks – All you need to know
Through 2020 – 2021, governments and central banks across the world had resorted to low interest rates and abundant money supply / liquidity in the economy. This was undoubtedly done to provide much needed support to world economy that was fighting a once-in-a-century pandemic in the form of Covid-19. However, as a result during that period debt investment opportunities were unable to yield returns that were commensurate to beat inflation. Also, for an Indian investor, where tax plays an important role in investment decision making, investors preferred allocating money to growth assets over fixed income investments.
The tide is now turning with Covid-19 behind us and Governments having to fight a new battle – against Inflation! In a matter of less than a year, we are seeing interest rates going up, liquidity getting absorbed and resultant uncertainty that we all as investors have to brace.
Now more than ever investors need to safeguard their portfolios against rising inflation, rising interest rates (rate and price of bonds are inversely related) and preserve their debt capital besides making a reasonable real return on this sum.
This quest for positive real returns with low to zero interest rate risk can be fulfilled by adding some degree of hold to maturity (HTM) high-yielding assets to the portfolio.
Market linked debentures (MLD) offered through the private placement route, can be a potential solution to provide this yield kicker in the portfolio. Market linked debentures can be designed in various forms and can be structured to provide different objectives to sophisticated investors under different conditions. Ones that are predominantly seen in current markets, are principal protected fixed income instruments issued by a single issuer which has coupon contingency based on fulfillment of a certain underlying condition.
For example, a 30-month MLD would pay the investor a pre-defined IRR at the end of the tenure if Nifty 50 Index does not fall by more than 75%. The perceived benefit that investors have in a structure like this is:
While the above example would be that of a simple structure, there are various other complicated structures like (a) principal protected with a participation rate linked to an underlying index, (b) principal protected structures which gives a pay off if equity markets go down, (c) less than 100% principal protection structures etc.
Due to the complexity of structures and higher minimum allocation, these structures are suitable for HNI and UNHI clients who understand the nuances correctly and are offered to them on a private placement basis.
What is very important here is to understand the risk associated with MLDs.
- Issuer’s Profile: Although majority of the structures are principal protected, the ability of the issuer to repay is of paramount importance. Investors may suffer a capital loss in case the issuer fails to repay on the obligation. Post the ILFS crisis, we have seen some stress in the economy on the credit side through rating downgrades and write offs. This has also affected MLDs issued by such issuers which now trade at a significant discount to par. Thorough due diligence on the issuer’s underlying business, its diversification and key financial ratios should be undertaken before investing.
- Fulfillment of the underlying market linked condition: Secondly, payment of coupon is contingent on a certain market linked condition. Investors need to place a probability on the fulfillment of the underlying market condition. In our example above, a 75% drawdown is a safe enough condition considering its in line with the drawdown during GFC which was a black swan event.
MLDs generally have a bullet repayment at the end of the tenure for both principal and coupon. In case of coupon bearing structures, the rate of coupon is contingent on the credit quality of the issuer. As we go down the rating chain, the interest rate goes higher. MLDs also get listed on the stock exchange which may provide intermittent liquidity in some cases.
Listed MLDs are tax efficient as compared to traditional fixed income options which are taxed at marginal rates, MLDs are currently taxed at 10% plus surcharge which makes them tax efficient specially for higher income bracket investors.
MLD Taxation Rules
Taxability if MLD is not listed on any recognised stock exchange in India:
If the Holding period of MLD exceeds 36 months then the gain on transfer will be a Long-Term Capital Gain eligible for beneficial Tax rate of 20% (plus applicable surcharge and education cess), otherwise the gain will be a Short Term Capital Gain and the normal tax rate applicable to Investor will apply.
Taxability if MLD is listed on any recognised stock exchange in India:
If the Holding period of MLD exceeds 12 months then the gain on transfer will be a Long-Term Capital Gain eligible for beneficial Tax rate of 10% (plus applicable surcharge and education cess), otherwise the gain will be a Short Term Capital Gain and the normal tax rate applicable to Investor will apply.
To summarize, HNI & UHNI investors who have a risk profile allowing investment in sophisticated high-risk products and who can meet the minimum investment ticket size could look out on selective basis to add fixed income type MLDs as a 5% to 10% allocation within the fixed income part of their portfolio. This will enhance the portfolio yield in a tax efficient manner, subject to performance conditions being met.
The above provisions will apply if the MLD is treated as Investment in the books of Investor. However, if the MLD is held as stock-in-trade then the gain arising on such sale will be taxed under the head “Income from Business and Profession” u/s 28 of the I.T Act,1961.