Market-linked debentures: Navigating the complex landscape of MLDs for your investment portfolio

As Market-linked debentures (MLDs) globally have assets under management (AUM) of around $2 trillion, Indian investors can include these more as part of their financial planning. 

However, while choosing an MLD, you should align it with your risk tolerance, financial goals, investment horizon, and market outlook. Moreover, considering the credit rating and thoroughly perusing the offer document are equally crucial in making a conscientious decision. Navneet Dubey of BT Money Today spoke to Vijay Kuppa, CEO of InCred Money, and discussed how to choose the right MLDs, who must buy, and why one must scrutinise MLD features before investing. Edited excerpts:

BT: To start with, can you help us understand what MLDs are? 

VK: Well, MLDs are hybrid instruments issued in the form of a bond, where the returns or interest received is dependent on the performance of the underlying market benchmark. Some examples of the underlying benchmark are the Nifty 50 Index, Nifty 100 Index, 10-Year G-Sec Index, etc.

There are two main types of MLDs: Principal Protected and Non-Principal Protected. As the name suggests, in Principal Protected MLDs, the invested principal is 100% protected at maturity, i.e. there is no downside risk. This means that despite negative returns on the Market Benchmark, you will always get back your entire principal at the end of the maturity period.

BT: How do MLDs work? 

VK: Well, the investing phenomenon is unique. When an investor invests in an MLD, the amount gets split into the Debt Component and the Market-Linked Component. The Debt component grows in value like a regular corporate bond. The Market Linked Component invests in instruments like Call Options that give the variable equity-linked payout. The values of both these components are added, which becomes the total value of the MLD at maturity. Refer to the illustration below to understand more.

BT: What are the main risks associated with MLDs that investors should be aware of while investing in debentures? How can investors protect themselves from such risks involved? 

So, there are three primary risks involved when investing in MLDs:

Market risk: The returns of the MLD depend upon the performance of the underlying Market benchmark. Usually, there is a minimum return (floor) and a maximum return (Cap). It also includes the risk of the underlying return going above the Cap.

How can it be Mitigated? - Principal Protected MLDs reduce Market risk, which means that there will not be any loss even if the underlying asset has a big loss.

Credit risk:  Credit risk refers to the risk that the issuer may be unable to honour the principal and the coupon payments. This is the same risk present while investing in a regular Corporate Bond.

How can it be Mitigated? - Investing in MLDs that are Secured and listed, with an Investment grade rating and an issuer with strong financials, reduces credit risk.

Liquidity Risk - MLDs may not have an active secondary market, making it challenging for investors to sell their holdings before maturity. MLDs are very customized, and the returns on the MLD are not fully realized till the maturity of the product. 

How can it be mitigated? - Invest in MLDs with a view of holding it till maturity. Alternatively, invest with platforms that can give you any time liquidity.

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BT: Can you tell us some benefits of investing in MLDs? 

VK: So, I can explain this to you through multiple use cases of MLDs:

Safety Net for first-time investors: MLDs provide a lower-risk path for those who have hesitated to invest in the stock market due to the fear of losses, as they can now participate in equities with the safety of principal protection.

Confused about the Stock Market? Get Peace of Mind: The decision to book profits at the correct time is very tricky. Selling your stocks and seeing the markets go up can be agonizing, and on the flip side, not selling and seeing the market crash can be equally painful. MLDs are amazing at solving this problem. Principal Protected MLDs allow you to remain invested in the Market without risking your capital and profits, so you get only the upside without the downside.

Diversification: For someone looking to diversify from Equity, MLDs provide a good alternative. MLDs have lower risk & volatility as compared to Equity. Since the downside is protected, the returns are less volatile and have lesser standard deviation (a measure of risk) than the Underlying Index returns; hence, the risk-adjusted returns are better. On the other hand, MLDs can give a much higher return than plain Fixed Income alternatives.

BT: How can one choose the right structured MLD for their investment portfolio? 

VK: MLDs can be structured in multiple ways – with different Underlying indices, tenors and different structures. Some MLDs can be more debt-oriented (conservative), some balanced, and some can be more equity-oriented (aggressive). Investors should understand their risk appetite while investing. A debt-oriented MLD can be chosen if the investor wants to diversify from equities. Whereas, if the investor is looking for equity-like exposure, they can opt for equity-oriented MLDs.

The investor should opt for MLDs that have an investment-grade credit rating and should also be secured and listed. These ensure that the credit risk is mitigated. Though theoretically, MLDs can be traded, finding liquidity is not easy. An investor should invest in MLDs with a view to hold it till maturity. Alternatively, prefer investing in MLDs on a platform that provides liquidity.

BT:  What is the outlook for the MLDs market in the near future? 

VK: MLDs are actually very popular investments globally, with AUM of around $2 trillion. Only institutions and ultra-high-net-worth individuals in India have invested in MLDs due to their perceived complexity, limited access, and higher ticket sizes. As the Indian investing ecosystem matures, investors are willing to explore options that provide diversification and reduce the total portfolio risk. This makes us optimistic about the outlook for MLDs in India.

BT: How are commissions paid to advisors and online platforms selling MLDs?
VK: The issuer of the MLD usually pays an origination or distribution fee to the primary platform that is distributing the MLD. This platform then shares a part of these fees with advisors and other online platforms that help it further down-sell the MLD issue. Usually, no charges or fees are levied on the end customers who purchase the MLD. The customer receives the exact returns as per the terms and conditions mentioned on the platform at the time of purchase with no deductions.

BT: How do MLDs score over other bonds and debentures? 

VK: MLDs can potentially give higher returns than Bonds and Debentures. MLDs are linked to an Equity Benchmark where you can get a higher upside without taking significantly higher risks, for example. In the MLD, the investor can get an XIRR of up to 14 per cent per annum (total absolute returns of 30 per cent over two years), whereas, in a bond with a similar credit rating, the XIRR would’ve been around 10 per cent. 

BT: How can one invest in MLDs?

VK: Usually, MLDs are available offline through wealth management outfits, but the ticket sizes are usually high. There are alternate online investment platforms where one can invest in MLDs at a lower-ticket size.