Structured products vs equity funds: Are Market-Linked Debentures a smarter net for HNIs?

I’m a 52-year-old HNI with a diversified portfolio across real estate, equities, and bonds. My advisor suggested allocating ₹50 lakh into Market-Linked Debentures as a part of structured products exposure. How do I evaluate whether the structure is actually in my favor and not overly complex?

Advice by Bhavik Thakkar, CEO of Abans Investment Managers Ltd

What global markets like Singapore, Dubai and London call Structured Notes or Structured Products is known as Market Linked Debentures (MLD) in India. Developed markets offer Structured Notes/Structured Products as OTC (over-the-counter) offerings, whereas in India, this product is offered as a debenture and hence is known as Market Linked Debenture in India. India’s Income Tax Act has also recognized MLD as an instrument taxed as per Section 50AA, along with Debt Mutual Funds.

How MLD is different from a normal debenture is that in a normal debenture, you get a fixed coupon at a predefined interval, like a half-yearly or yearly coupon. Whereas MLD is also a debenture, the returns you get from it are not fixed but are linked with a “Market” instrument like the Nifty 50 Index, stock price, or commodity like Gold or Silver.

For example, if an investor is bullish on the equity market, he can participate through directly buying stocks or Equity Mutual Funds or Equity PMS. The same investor can also participate in equity markets through Nifty-linked MLDs. For different risk appetites, there are different MLDs available. For any conservative investor, there are products where you get the higher of a minimum coupon (say 6.5% p.a.) or Nifty returns (say up to 25%) in 18 months – whichever is higher.

For aggressive investors, there are participation-oriented products like for the next 2 years, up to 30% growth in Nifty, you get 150% participation. This means if Nifty grows by 30% in 2 years, the investor receives 45% absolute returns. In other words, the investor generates 50% “alpha” over Nifty returns by product design. These participation-oriented products may come with a feature of Principal Protection, meaning if the Nifty exit value is lower than the Nifty entry value, the investor does not suffer a loss and gets the principal amount back. A typical Non-Principal Protected product offers higher participation (170%-200%) as a bargain for not offering principal protection.

Given the above features, the investor should treat MLD as part of the equity asset class from an allocation perspective. The shortcoming of MLD is that it is a locked-in product, unlike a Mutual Fund, which can be exited anytime. The good news is that MLDs are available for tenors from 15 months to 36 months, so despite being illiquid, the investor can choose the tenor as per need. MLDs are subject to credit/default risk of the issuer, so the investor should select an issuer that has a long track record and should check the history of past products and their timely repayments.

MLDs, when included in a portfolio with equity MF, work like a stabilizer. In a falling market, the principal protection feature of MLD protects the value of the portfolio. In a rising market, higher participation enhances portfolio return, and in a sideways (time correction) market, a product like Fixed Income or Nifty–whichever is higher–will take away the asset allocation worry from the investor.

Taxation of MLDs

MLD is taxed as per the investor’s slab rate under Section 50AA of the Income Tax Act. This means income from MLD up to Rs. 12 lacs as per the new tax regime is not taxed. However, if the same income is generated from investing in equity MF or stocks, the investor has to pay LTCG of 12.50% even for income up to Rs. 12 lacs because equity MF or stocks’ LTCG is taxed at a special rate of 12.5% and not as per the slab rate.

A lot of investors prefer to invest in MLD for their family members who do not have any business or salary income, and hence, income generated from MLD up to Rs. 12 lacs is not subject to tax. Even people in the 30% tax bracket might prefer MLD as it could generate higher returns through participation rates like 140-150%, meaning for a given level of Nifty growth, if you make 1.4 to 1.5 times of that, you will still make a better post-tax return even after paying 30% tax on MLD as against paying 12.50% on Equity MF or stocks.