Imagine a new restaurant comes up in your neighborhood with a discount policy that if the stock market is up at the time of your billing, you get a discount of 20 percent on the total amount. Whereas, if the stock market is down, you get a discount of 5%. In such a case, you would be tempted to gamble on the stock market for an enhanced discount.
Market-linked debentures are somewhat similar to this, except the returns are dependent on a market index. Let us understand in detail.
Market-linked debentures (MLDs) are securities that offer investors the potential to benefit from market movements while providing a return of principal at maturity. They are debt instruments issued by companies or other entities linked to the performance of an underlying asset, such as a stock index, basket of stocks, or other financial instruments.
Let us understand their working with an example.
How do market-linked debentures work?
In principal-protected MLDs, even if the conditions are not met, the investor does not lose its principal amount.
For instance, a company named AA issues MLDs and pays a coupon of 6% per year, maturing in 10 months. But that 6 percent is only given on a condition: the S&P 500 index does not fall 10 percent in price when measured exactly on the 9th month.
If the condition is not met in the 9th month, you get only your principal back without any interest amount.
In non-principal protected MLDs, the issuer company may also choose not to pay the principal amount in the event that the underlying market index performs poorly. According to SEBI regulations, only principal-protected MLDs may be issued in India.
What are the primary benefits of market-linked debentures?
Lower Risk: MLDs have lower risk than traditional investments because they are not directly affected by changes in the interest rate. Besides, the investor's capital is protected even if the underlying asset declines in value.
Flexible: MLDs offer investors more flexibility in terms of when they receive their returns. They can choose to redeem their investment before the maturity date or keep their investment until maturity.
Diversification: MLDs provide investors with a way to diversify their portfolios and hedge against risks. By investing in a variety of MLDs, investors can spread their risk across different assets.
What are the risks associated with market-linked debentures?
Market Risk: The performance of the underlying asset is subject to market fluctuations. If the market experiences a downturn, the value of the debenture will decrease and the investor may suffer losses.
Credit Risk: MLDs also carry credit risk as the issuer may default on its payments. Investors must research the issuer to ensure that it is financially sound and has the capacity to make interest payments and repay the principal at maturity.
Liquidity Risk: MLDs typically have longer maturities than traditional debt, which means they are less liquid. Investors may have difficulty selling their investments before maturity if the market sentiment changes.
How are market-linked debentures taxed?
Changes in the taxation of income from market-linked debentures were announced in Budget 2023. The revenue from MLD will now be taxed at the investor's slab rate as opposed to the previous taxation of 10%.
The Finance Bill 2023 has added a new rule that applies from April 1, 2023. Any profits made when transferring MLDs will now be treated as short-term capital gains and taxed at the applicable rate for the investor, rather than being treated as long-term capital gains and taxed at 10%.
This means high net worth individuals and companies will be taxed 30% plus surcharge on their profits. Additionally, the exemption on tax deducted at source (TDS) on interest income earned on listed debt securities including MLDs has been removed, so TDS must now be deducted at 10% on such interest income.
This rule also holds true for MLDs you currently own but sell or mature after April 1, 2023. The best course of action is to sell these MLDs right away, if at all feasible, in order to take advantage of the current tax benefit.
The bottom line
Market-linked debentures offer investors the potential to benefit from market movements while providing a return of principal at maturity. While they come with some risks, they also offer lower risk and greater flexibility than traditional investments and can provide investors with a way to diversify their portfolios and hedge against risks.
However, it is important to note that the taxation rules on revenue from MLDs have changed in Budget 2023 and investors should be aware of these changes before investing in MLDs.