Mld Investment Guide: Strategies For Indians

Market Linked Debentures (MLDs) are structured fixed-income products that combine the attributes of investments in bonds and equities. MLDs are debt instruments where the returns are linked to the performance of an underlying financial market index. The market index, also called the underlying index, could be equity indexes like NSE Nifty, Sensex, government securities, gold index fund, or Nifty Index fund, etc. The returns are determined on the basis of the performance of the underlying index and are received by the investor only at maturity. MLDs are of two types: Principal Protected MLDs and Non-Principal Protected MLDs. In this response, we will explore the basics of MLDs and how to invest in them.

Principal-protected MLDs

In a principal-protected MLD, the investor's principal amount is safe from the performance of the external benchmark, usually a stock market index. The maximum loss for the investor is the interest. These MLDs are not entirely risk-free, as credit risk still applies. Therefore, it is essential to evaluate the credit risk by checking the credit rating of the issuer.

The tenure of principal-protected MLDs typically ranges from 12 to 60 months, and the minimum investment amount is Rs. 1 lakh as of January 1, 2023.

Non-principal-protected MLDs

In India, only principal-protected MLDs are issued, as per SEBI regulations. However, even with principal-protected MLDs, investors should be aware of credit risk. This means that there is a chance the issuing company may default on its payments, and investors should evaluate the creditworthiness of the issuer before investing.

When deciding whether to invest in non-principal-protected MLDs, it is essential to understand your risk tolerance and conduct thorough research. These investments are complex and may not be suitable for all investors.

Taxation on MLDs

Market-linked debentures (MLDs) are debt instruments whose returns are linked to the performance of an underlying financial market index. The market index, also known as the underlying index, could be equity indexes like NSE Nifty, Sensex, government securities, or any other index/basket of stocks.

MLDs have become popular among investors due to their shorter holding periods for lower capital gains tax rates. Before April 1, 2023, if an investor held an MLD for more than a year and then sold it, the returns were classified as long-term capital gains and were taxed at a lower rate of 10%. This was seen as an arbitrage opportunity, as investors could enjoy lower tax rates on their returns.

However, this has recently changed, and gains from the sale of MLDs will now be taxed as short-term capital gains. This means that the returns will be taxed at the investor's applicable tax slab, which could be higher than the previous 10% rate. This change was implemented in the Finance Act 2023, presented by Finance Minister Nirmala Sitharaman on February 1, 2023, and took effect on April 1, 2023.

Now, any gains derived from transferring MLDs will be automatically classified as short-term capital gains (STCG) and taxed at the applicable tax slab rate of the investor, irrespective of the holding period and listing status. This has eliminated the previous benefit of a lower tax rate for long-term capital gains on MLDs. Additionally, the tax deducted at source (TDS) exemption that was available for listed MLDs has now been removed.

Despite these changes, MLDs still offer some tax advantages over other investment options. MLDs are now the only debt instrument whose income will always be treated as STCG, regardless of the holding period or whether the investor sells it in the secondary market or holds it until maturity. This short-term capital gain is taxed at the same rate as interest, and investors can set off any short-term capital losses carried forward from the last eight financial years.

In summary, while the taxation of MLDs in India has recently changed, they still offer some tax benefits compared to other investments. Investors should carefully consider the tax implications and their own risk appetite before investing in MLDs.

Risks of investing in MLDs

Market-Linked Debentures (MLDs) are not risk-free. In addition to the risks that other bonds are subject to, they carry the added risk of market performance. Here are some of the risks associated with investing in MLDs:

Market Risk

The returns on MLDs are linked to the performance of a specific market index, which is influenced by various factors such as the growth of the domestic economy, inflation, foreign economic conditions, and the stability of the government. In the case of adverse market scenarios like a recession, the performance of the index may be negatively impacted, and investors may earn a 0% return or even face capital losses. Therefore, investors must analyse and understand the market and the linked index before investing.

Credit Risk of the Issuer

MLDs carry the risk of the issuer company defaulting on its obligations. Investors need to assess the creditworthiness of the company and understand the potential risk of default. It is recommended to invest in MLDs issued by companies with investment-grade ratings to mitigate this risk.

Liquidity Risk

MLDs are not as liquid as other debt instruments like bonds because they lack a secondary market, meaning investors cannot easily resell them.

Reinvestment Risk

MLDs typically do not have interest payments, which means there is no need to worry about reinvestment risk. However, this also makes them more volatile than regular bonds.

Interest Rate Risk

MLDs are subject to interest rate risk, which is a common risk associated with fixed-income investments.

Fulfillment of Underlying Conditions

The gains from MLDs depend on certain market conditions being fulfilled. Investors need to accurately predict the probability of those conditions being met.

Credit Rating

The credit rating of the firm issuing the MLD plays a crucial role in attracting investors. A low credit rating may indicate a higher risk of default, and investors may suffer capital losses if the issuer fails to repay its obligations.

Benefits of investing in MLDs

Market Linked Debentures (MLDs) are a type of non-convertible debenture where returns are linked to the performance of a market index. Here are some benefits of investing in MLDs:

Diversification and Higher Returns

Every investor should have a portion of their portfolio in fixed-income instruments to diversify their portfolio and ensure some minimum return. MLDs are one such instrument that can provide higher returns than traditional fixed deposits.

Limiting Market Downside

In the case of equity investments, there is a risk of partial or complete capital loss if the markets perform poorly. MLDs, on the other hand, are principal-protected, meaning that investors will at least get back their principal invested, thus avoiding capital erosion.

Benefits for Issuers

Issuing MLDs provides companies with a way to borrow money from the capital markets, offering diversification in borrowing profiles, especially for NBFCs. Additionally, issuing MLDs can provide companies with more ISINs, which is beneficial for high-value debt companies with significant debt borrowing from the capital market.

Better Tax Treatment

MLDs enjoy a more favourable tax treatment compared to other types of bonds and debentures. Until March 31, 2023, listed MLDs were taxed as long-term capital gains if held for more than 12 months, resulting in higher post-tax returns than regular NCDs. However, as of April 1, 2023, capital gains on MLDs are now treated as short-term capital gains, taxed according to the investor's tax slab.

Frequently asked questions