By Bhavik Thakkar
SEBI reduced Market Linked Debenture (MLD) ticket size from Rs 10 lac to Rs 1 lac from 1st January 2023 and finance minister Nirmala Sitharaman announced changes in taxation for MLD in union budget 2023. From the personal finance point of view, a lot of investors and financial intermediaries are curious to know more about how MLD as a ‘predictable passive’ instrument can help enhance their investing experience.
Isn’t MLD same as Derivatives and Derivatives mean speculation?
Derivatives in financial markets are hedging/risk management tools. Within mutual funds, Equity Arbitrage Funds also use derivatives to create arbitrage positions (buy stock and sell stock’s futures contract) to achieve the desired outcome (arbitrage profit in this case). So, derivatives (futures & options) are not tools for speculation. It’s a different thing that traders use them to have leveraged position to trade and because of leverage, the risk is higher hence general perception is derivatives are risky and meant for speculation. So, the way Equity Arbitrage Mutual Fund’s fund manager uses derivatives to achieve desired results, the issuer of MLD also uses derivatives to generate returns promised to investors.
Hasn’t MLD become a thing of past given changes in taxation introduced in budget?
In India, MLD issuers can be divided into 2 categories. The first category offered pure “fixed income” oriented MLD purely from a better tax efficiency perspective. For example, say ABC Ltd offered normal NCD at 9% rate of interest and MLD at 8% rate of interest. An investor in the 30% tax bracket found it lucrative to invest in MLD as he had to pay only 10% tax on 8% MLD as compared to paying 30% on 9% NCD. Since ‘post-tax’ returns were better in MLD and it also reduced the cost of borrowing for ABC Ltd by 1%, it was a win-win proposition which led to almost Rs. 75,000 cr worth of MLD being issued in the last 5 years. For this category to survive, the borrowing cost (interest rates) have to match up with post-tax returns from other debt instruments such as Bank FD, Debt Mutual Funds or Corporate FDs.
The second category of issuers is “Wealth/Investment Management” entities that offered Nifty 50 index-linked MLDs which generate variable returns based on the performance of the Nifty 50 index on similar lines as how a Stock Portfolio or Large-cap Mutual Fund or Index fund would perform. So, MLDs generating returns based on the performance of the Nifty 50 Index is also one additional instrument available to investors along with Large-cap Mutual Funds or Index Funds.
How is MLD – a predictable passive? How is it useful to investors?
If you compare the last 5 years’ return of the Nifty 50 Index and that of Large-cap Mutual Funds, you would notice that the Nifty 50 Index has out-performed almost 80% of funds. This clearly explains why investors are incrementally looking at investing in passive instruments like Index Funds. But, when you invest in Index Funds, you get index returns. How do you outperform an index? By investing in MLDs which are ‘designed’ to outperform Index. So where a mutual fund’s fund manager uses ‘stock selection’ as a method to outperform the Nifty 50 Index, an MLD allocates money to Nifty 50 Index derivatives to outperform the Nifty 50 index by ‘design’ eliminating human bias/error of judgement. For example, if you invest in an MLD which says it will generate 200% participation (2 times) of Nifty 50 Index returns upto the next 20% growth in Nifty in the next 2 years. This would mean, if the Nifty 50 index delivers say 20% or more returns, the MLD would generate 40%. There is no magic here, the MLD allocated funds to Nifty derivatives in such a way that the derivatives will yield 40% if the Nifty 50 index grows up to 20%. This brings in the predictability aspect, before you invest in MLD, you get a scenario analysis table showcasing what will be MLD return for a given level of Nifty 50 index return (even for negative returns) so based on the investor’s view of the future growth of Nifty 50 Index, one can select MLD. There are also MLDs which provide the best debt or equity returns which may suit conservative investors, especially in the current environment where the Nifty 50 Index has generated nil returns in the last 18 months.
Wouldn’t higher tax on MLD make it unattractive compared to Mutual Funds?
Only 1 cr people in India are in the 30% or higher tax bracket. In the example quoted above where MLD generates a 40% return, even if one pays 30% tax on it, the post-tax return would be 28% and as we know that since most Large-cap Mutual Funds are generating the same or lesser than Nifty 50 Index returns, it would mean Nifty 50 Index/Large-cap MF will have to generate around 31% pre-tax return and when 10% Long Term Capital Gains Tax is paid on 31%, the investor generates 28% post-tax return. So, to generate the same level of post-tax return, a mutual fund would require Nifty to generate 31% whereas MLD would do the job even at 20% Nifty growth. People who are in the lower or Nil (a lot of people in the 30% tax bracket would have family members in the lower or Nil tax bracket) would find it much more lucrative to invest in MLDs as their tax outflow will be much lower.
Mutual Fund Industry is 40 lac crore now; What is future of MLD industry?
MF industry had its challenges in the early 2000s with respect to investor and distribution community’s confidence (US 64 scheme of UTI), regulatory changes related to entry load ban, exit load ban, a ban on upfront commission, lower expense ratio etc. Despite all these challenges, the industry grew leaps and bounds as it offered a ‘solution’ of investing in debt and equity markets with ‘fund management expertise’- a pooled vehicle for mass fund management. It is this ease and expertise that helped the MF industry grow. MLD as a product category brings in ‘predictability’ as a unique aspect which is the need of people who have grown as ‘investors’ in the last 2 decades along with the growth of Mutual Funds and Insurance. The emergence of technology has led to the free, easy and quick availability of information/analytics which coupled with MLD’s capability of being ‘designed’ to generate targeted pay-off is the perfect blend for MLDs to grow and become…. The Predictable Passive.
(Bhavik Thakkar is the CEO of Abans Investment Managers Pvt Ltd. Views expressed are author’s own.)