MLDs are hybrid or structured products that invest in both fixed income and derivative instrument to generate higher returns than plain vanilla debt securities. The returns earned on these instruments are based on the performance of the underlying index like Nifty 50 or G-Sec. Most MLDs offer a guaranteed return of principal even if the underlying index does not perform well. Thus, these are called principle-protected MLDs (PP-MLDs).
Let us take Nifty 50 (currently trading at around 17,300) as the underlying index. For example, PP-MLD may offer to pay a coupon of 15% if Nifty crosses 19,000 at the end of its tenure. In this case, the MLD issuer enters into a derivative contract with a certain amount of raised funds, betting on the market’s upward move to generate higher returns. If the condition is not met, only the principal amount will be paid by the issuer.
In the above example, even if the Nifty is at 20,000 or 25,000 on the maturity date of the MLD, the coupon is fixed at 15%. Such devices are called fixed-coupon MLDs. There are also MLDs with variable coupon rates in which the interest rate is tied to the performance of the underlying index. For example, suppose, a PP-MLD offers a coupon with a participation rate of 85%. In this case, if Nifty gains 15% till the date of maturity, the variable interest rate for the entire tenure of the MLD will be 12.75% (15% * 85%).
Thus, through a well-structured MLD, one can profit from the rising market while protecting one’s capital. Most MLDs come with tenure of around 14-60 months.
“A bear market can be a great time to invest in MLDs, if they are structured properly. A convertible coupon PP-MLD structure helps to participate in the uptrend when the market has fallen and if you expect Nifty to recover in the next two-three years. Even if the idea turns out to be wrong, the investor will get the principal back,” said Manish Jelloka, co-head, product and solutions, Sanctum Wealth.
Note that there is also a non-principal protected MLD (NPP MLD) category that offers high potential for reverse capture with limited or no downside protection. However, only PP-MLDs listed on the exchange come under the purview of Securities and Exchange Board of India (SEBI) regulations.
The major advantage of MLD instruments is their tax treatment. Returns on investment in listed MLDs are taxed at 10% as long-term capital gains if sold in the market after one year. This is 20% (with indexation) as compared to the holding period of three years for debt mutual funds and higher than the slab rate tax for interest earned on FDs. But tax benefit is available only if the securities are sold before maturity. Typically, wealth management firms promise to ‘buy back’ their MLDs just before maturity to the clients to pass on the benefit of 10% LTCG to the clients.
Thus, the returns after MLD become attractive to those with higher slab rates. Minimum investment amount 10 lakh in MLD also makes them accessible only to HNIs. However, if the MLD is held till maturity, the gains will be taxed at the slab rate of the investor, which will reduce the attractiveness of this product even for high net worth individuals.
MLDs are considered high risk due to the linkage of returns to the market performance of the underlying index. The risk of the underlying index not meeting the conditions set by the PP-MLD is called market risk. “The derivatives portion of the MLD is structured to generate returns on such underlying instruments based on bullish, bearish or range-bound view. For example, MLD can generate higher returns if Nifty crosses 20,000 by December 2022. If this scenario does not work, there may be no return from the structure. “This risk is evident on the face of the product note,” said Harish Menon, co-founder of House of Alpha.
Second, companies that raise funds through MLDs are mostly categorized from AAA (highest ranking) to BBB (low ranking). Thus, credit risk—the risk of default or delay in payment of maturity amount by the issuer—is significant in MLD.
Credit risk is the reason why some financial planners shy away from recommending MLDs to their clients. “I don’t think MLD structures are bad, but I am concerned about the credit risk that comes with these products,” said Vishal Dhawan, Founder and CEO, Plan Ahead Wealth Advisors.
While the credit rating assigned to an issuer is a way of assessing the creditworthiness of the issuer, it cannot be confused with the issuer’s ability to pay coupons, which is dependent on a market index. Firoz Aziz, Deputy CEO, Anand Rathi Private Wealth Management said, “The AAA rating is not solely for the MLD but only for the credit portion.”
Menon also pointed out the counterparty risk of these MLDs due to trading derivatives on the over-the-counter (OTC) segment, which is traded directly between the two parties without the supervision of any exchange (NSE or BSE).
“The options listed on the exchanges have limited liquidity beyond the maturity of 1 year. If the MLD is issued for 3 years, it should ideally include options for 3 years. For this, MLD issuers resort to OTC options that are traded with a specific institutional counterparty. There could be a scenario where this counterparty defaults on profit payments if the market outlook is correct and the MLD makes profits,” Menon explained.
Finally, poor liquidity for these instruments in the secondary market creates a liquidity risk if the investor wants to exit before the maturity date.
Considering the complexity of the product structure and due diligence, MLDs are suitable only for well-informed investors who can leave the investment untouched till the maturity date.
“MLD is a product that was never designed for the retail market or the common investor. The benefits of MLDs are very different than those of the general investor. In the case of HNIs, too, from the market,” said Punit Agarwal, Founder-Director, BondsInida. Selecting the right MLD matters the most to generate efficient returns associated with it.
The charges on issuance of MLD work the same as for the primary issuance of a bond/debenture. Usually no separate charge is taken from the investor. “There is an embedded fee payable by the issuer to distributors such as arrangers. Thus, there is no direct impact of the charges levied by the issuer on the returns earned by the investor,” said Joydeep Sen, an independent debt market analyst.
According to the study, which took into account various case studies (information selected from stock exchanges and companies’ websites), the negative conditions on which the coupon rate is based are highly unrealistic. “An instance where the value of the Nifty or G-Sec would fall by 50-75% – in this case a 0% return is paid – seems quite improbable. So in almost all situations, the investor will always receive a coupon and this the type of hedging shown is a hoax. Thus, MLDs are not market linked at all, thereby defeating the purpose of introducing these instruments,” the report highlighted.
The study shows that many MLDs are not market-linked but are actually equivalent to plain vanilla debentures. Thus, if one invests in MLD to accelerate the market, it may not happen. Sometimes, it can be like investing in a normal debt security.