Market-Linked Debentures Are Popular, But Are Losing Their Preferential Tax Status, What Lies Ahead?

Market-linked debentures are catching the attention of investors these days. As they lose their preferential tax status, and their returns are treated as short-term capital gains, how much of their appeal will they lose? Are they still a good investment option? Read on to find more

In Union Budget 2023, the Centre announced that market-linked debentures (MLDs) will no longer benefit from the preferential tax treatment that they previously enjoyed. 

What Are MLDs?

Market-linked debentures are non-convertible debt instruments that provide income linked to a certain financial market index, such as the Nifty 50 Index or stock. 

Unlike bonds that pay a fixed interest rate either monthly, quarterly, half-yearly, or annually, MLDs do not pay coupons prior to the maturity period. Maturity periods could range from one year to five years.

The risk they carry for investors vary depending on the conditions laid out by the issuer in the debenture prospectus. Issuer should have a minimum net worth of at least Rs 100 crore at the time of issue.

According to the Securities and Exchange Board of India (Sebi), market-linked debt securities “have an underlying principal component issued with market-linked returns obtained through exposures on exchange traded derivatives or MIBOR, GDP, inflation rate, underlying securities/indices etc. with coupon linked to a benchmark different from plain vanilla debt securities.”  

Who Can Purchase MLDs?

An MLD comes with a face value of Rs 10 lakh, which made it popular with high networth individuals (HNIs). Sebi has since January 1, 2023 reduced the face value to Rs 1 lakh, thus enabling individual investors to also move into buying MLDs.

How MLDs Work?

The return on MLDs is determined by the performance of the underlying index. 

In case of an MLD that promises 1.3 per cent for every 1 per cent gain on the Nifty 50 Index, the investor will only receive their principal back if the index generates negative returns by maturity. Investing in this option is less risky than investing in stocks, where your investment capital could even get lost.

In the past, HNIs had also gravitated to these investments, since capital gains on these listed debentures held for more than one year were only taxed at 10 per cent. 

Comparatively, MLDs were known to offer more than the yield amount of bank fixed deposits.

MLDs Without Principal Protection

There is also another type of MLD that does not offer principal protection. 

But according to Sebi, debt securities which do not promise to return the principal amount in full at the end of the tenure of the instrument cannot be issued under the MLD category. 

It should be noted that even in MLDs that offer principal protection, the payouts are subject to the credit risk of the issuer. MLDs with principal protection are rated by credit rating agencies. Those with AAA and AA+ ratings are considered low-risk instruments.

Sebi mandates that issuers of MLDs should prominently display the risk factor, since the return is not fixed and instead depends on the underlying index. 

Typically, the conditions determining the returns were framed by issuers in such a way that market fluctuations have minimal effects, while investors receive a tax treatment similar to equity investments.

With the advantage of such a preferential treatment gone, now MLD returns are treated as short-term capital gains (STCGs) with a slab rate similar to other debt investments. By investing in MLDs, HNIs earned higher post-tax returns than by investing in comparable fixed income instruments. After the Centre has pulled the plug on preferential tax treatment for MLDs, these investments are no longer as attractive as they once were.

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