Afraid of market crash? Opt for market-linked debentures
Authored Article by Aditya Damani, Founder and CEO, Credit Fair
The biggest fear of an investor is the possibility of a wipeout of his entire investment. But there are ways to protect a part of the invested money while deriving maximum mileage out of market movements. Market-linked debenture (MLD) is a good tool in this regard. MLDs help people to remain invested in volatile market conditions without risking their capital.
Market-linked Debentures
MLDs are hybrid financial instruments similar to bonds, which are broadly classified into two: Principal-protected and Non-principal-protected. In the case of principal-protected debentures, the invested money is fully protected at maturity. That means, there is no fear of losing full investment. Even if the underlying benchmark to which the MLDs are linked is showing negative returns, the investor will receive his principal back at the time of maturity.
Capital Protection
The decision to book profit at the right time is very hard for new investors. For them, MLD is a good product that offers capital protection. However, one should take into account his/ her risk appetite, liquidity concerns, investment horizon and market conditions before investing in MLDs as it is ideal for long-term goals. Please note that the investor will not get any fixed annual return. It is similar to a zero-coupon bond that pays principal plus interest when the investment attains maturity.
Investment Structure
When an investor puts money into MLD, the total investment gets split into two components: debt and equity (market-linked). The debt component grows like bonds or government securities (G-sec) and the equity component goes into equity or equity-linked instruments. At maturity, returns from both streams will be added and the investor will get the total amount.
Various Options
Investors can choose different types of MLDs based on their risk profile and investment horizon. Some MLDs have more debt components. Some have higher equity allocation. And some may have balanced allocation. Also, MLDs can have different structures. They may be linked to different benchmark
indices like Nifty 50, Nifty 100, or Nifty 500, and they may have different tenors. Investors can choose MLDs on the basis of their future financial goals.
Safety Features
The primary safety indicator of an MLD is credit rating. The instrument should have an ‘investment-grade’ credit rating. Also, it should be ‘secured’ and ‘listed’. If it is secured, the investor can seek legal remedies when the issuer fails to return money at maturity. If it is listed on a platform, the investor can sell MLDs at any time. No need to hold it till maturity. Moreover, a listed instrument is more transparent than an unlisted one. But, to get maximum returns, it is advisable to hold MLDs till maturity. Before making an investment decision, the investor should read the offer document carefully.
Risk Factors
The returns from MLDs depend on the performance of the underlying benchmark index. If the index is giving positive returns, the investor can expect good returns. However, principal-protected MLDs can mitigate such market-related risks.
Another risk is default risk. When the MLD issuer fails to pay back the principal plus interest at maturity, then arises default risk. Verify the issuer’s financial conditions before investing in MLDs. It will minimize default risk. If the MLDs are listed, the investor can sell them in the secondary market before maturity. If the MLDs are secured, the investor can have a claim on the issuer’s assets in the event of a default or company liquidation.
Next is liquidity risk. MLDs are not as liquid as equities or G-secs. So, the investors may find it difficult to liquidate them in the case of an emergency. Remember, it is advisable to invest in MLDs with a long-term perspective. That’s the right way to avoid liquidity-related risks.
A notable downside is that returns from MLDs are taxed as short-term capital gains, which will result in a higher tax outgo of up to 30 per cent. Earlier, it was taxed at 10 per cent if invested for a period of more than one year.
Conclusion
MLDs can offer higher returns than ordinary fixed-income securities or sometimes than bonds and other debentures. In global markets, MLDs are very popular. But in India, so far, only institutional investors and high net-worth individuals (HNI) have shown interest in them. Retail investors usually stay away from MLDs due to multiple reasons such as higher ticket sizes, lower liquidity and limited access. Access issues arise from the fact that they are generally marketed offline in India. However, of late, some alternative investment platforms are offering them online. So, if you wish to be free from the worries of a total loss during turbulent times, go for the MLDs.
Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.