Market-linked Debentures: Tax-efficient Investments With Reasonable Pay-offs 

A market-linked debenture does not pay any coupon before maturity.

In a common debenture or bond, the coupon payable is defined: say, 7 per cent every year. There are certain floating rate debentures that carry coupons linked to a benchmark. So, if the benchmark is the MIBOR (Mumbai Inter-Bank Offer Rate) and there is a mark-up of, say, 0.5 percentage point over the MIBOR, then coupon is determined on the basis of MIBOR movements.

Terms-based pay-off

A market-linked debenture does not pay any coupon before maturity. On maturity, apart from the initial principal component, there is a pay-off, i.e., a return payable. This pay-off depends on the movement of a security or index, as defined initially in the terms of the MLD. For example, if the underlying index is Nifty 50 and the terms say X per cent of the upside movement of Nifty is payable, then Nifty’s movement decides the return. If the terms say 75 per cent of the upward movement of the Nifty 50 is payable, and if the Nifty rises 20 per cent from the initial level till the observation date, then 15 per cent is the return (non-annualized) over the tenure of the MLD.

Instead of investing in an instrument where the pay-off depends on the Nifty’s movement, why not invest directly in Nifty? There are principal protected (PP) structures, which protect your initial investment, irrespective of the movement of the underlying instrument or security. That is, you get the upside return potential in the other market, e.g., equity (NSE Nifty) or G-Secs or gold, without taking as much of a risk as investing directly into those assets. If you invest directly in the Nifty or gold and Nifty or gold value declines over the investment horizon, you would lose a part of the principal. In a PP structure, in the worst case, you will get zero return even if the underlying security or index gives negative return; but, you will get your investment amount back.

For discussion purposes, there are two kinds of MLDs: fixed coupon and variable coupon. In an MLD, the pay-off is not fixed, but linked to a reference underlying security or index as mentioned earlier. In a so-called fixed coupon, the range of the reference security or index is fixed so wide that it is almost certain that you get the return initially indicated. In a “variable coupon,” there is a real or palpable linkage to the reference market. The tenure of MLDs usually ranges from 13 months to 60 months, depending on the issuer’s funding requirements; the average tenure is little less than three years.

How you can buy

We will discuss one MLD here, which will give you a perspective. REC (formerly Rural Electrification Corporation Limited) is a Government of India Enterprise. The company floated an MLD, the private placement (primary issuance) for which happened on July 6, 2020. Subsequent to the primary issuance, it is now available in the secondary market. The terms of the product are:

-Principal Protected (PP) MLDs, principal protected at maturity (not in the interim);

-Unsecured, Redeemable, Non-convertible debentures, ranking as senior debt;

-Redemption date, June 30, 2023; initial fixing date July 8, 2020; final fixing date  March 31, 2023;

-Underlying index: yield of Government Security 6.45 per cent GoI 2029 ISIN INE0020190362 maturing October 7, 2029;

-Credit Rating PP MLD AAA by CRISIL and ICRA.

What will be your return? The yield on the underlying, the G-Sec mentioned above, is assumed as 6 per cent for simplicity. If the final fixing level  is greater than 50 per cent of the initial fixing level, i.e., more than 3 per cent, then you get the committed coupon. The committed coupon is 5 per cent annualized, calculated on a XIRR basis. If the final fixing is less than 50 per cent of initial level, i.e., less than 3 per cent, then there is no coupon, you just get your principal back. However, practically, the possibility of the yield falling to as low as 3 per cent is remote. Hence, this may be described as a “fixed coupon” structure.

What do you need to check? In the initial issue document, the private placement offer letter, check the clause on “eligible investors” and whether individuals are allowed to invest. In this case, individuals are allowed. What is the minimum investment amount? The face value per debenture is Rs 10 lakh; so, that is the minimum amount. In the primary issuance, the minimum application amount was Rs 1 crore, but that is not applicable in secondary transactions. In the secondary market, it is currently available at a yield of more than 5 per cent (the committed coupon), which is good for investors.

Tax-efficient instrument

Taxation of this instrument is efficient. These are listed on the exchanges and capital gains from listed debentures, after a holding period of more than one year, are taxable at 10 per cent (plus surcharge and cess). There are non-listed MLDs also, but those are not tax efficient. The MLD has to be sold in a secondary market deal just before maturity. Hence, there is no coupon flow in between your investment date and sell-off in the secondary market, and your returns are capital gains from the secondary market deal.


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