MarketLinked Debentures – Real or Illusory?
Aanchal Kaur Nagpal and Shreya Masalia
Vinod Kothari and Company  corplaw@vinodkothari.com
Introduction
Market linked debentures (MLDs) are a type of debt security that provides returns based on the performance of an underlying index/security. When the underlying security does well, the return on MLDs will be high and viceversa. While the underlying security to which the MLDs are linked is at the discretion of the issuer, the same, however, needs to be related to the market, e.g. indices such as Nifty 50, SENSEX etc., or securities like equity, debt securities, government securities etc. For an indepth understanding of the concept and the regulatory framework of MLDs, read our article here.
The previous article touched upon the concern of MLDs being used for the purpose of regulatory arbitrage, without being truly marketlinked. The regulatory arbitrage may come in the form of additional ISINs, exemption from EBP mechanism, etc. The same has been discussed in detail in the previous article.
In this article, we shall examine various case studies (picked from various information memorandum available on the stock exchange and websites of companies) to prove the point.
The case studies are tabulated below:
S. No.  Underlying  The basis for coupon payoff  Likely/unlikely conditions 
1.  NIFTY 50  If final fixing level > 25% of initial level, coupon – 8.1767% (XIRR 8.000%)
Suppose, So, if the final fixing level is above a value of 2850, then coupon pay off will be 8%. 
Conclusion –
This condition is highly unlikely to happen. Looking at past trends, the probability that NIFTY 50 would fall below the level of 2850 is very low. 
2.  NIFTY 50  If Final >= Initial, Principal Amount * 20.50% If Final < Initial, Principal Amount * 19.65% 
Conclusion This is a likely condition. However, in all cases, the investor is going to receive coupon payoff, even if the underlying performs negatively, there is a payoff.The level of rise in Nifty is not related to the return that the investor will receive. i.e. if the initial level is 10,000 and nifty either rises to 20,000 or 10, 200, the return will be the same. Difference between coupon payoffs in both the scenarios i.e. whether the underlying performs or not is less than 1%. 
3.  Gsec  The initial fixing level is 105.94 (which is the price of Gsec on the initial fixing date)
Suppose,

Conclusion –
The downside condition is highly unlikely to happen. The probability that the price of the Gsec on the final fixing date will fall below 26.485 from a level of 105.94 is very low. In fact, on the final fixing date, the price of the Gsec was 108.17 which is higher than the initial fixing level. 
4.  NIFTY 50  Initial level – an average of 6 observations Final level – an average of 6 observations Nifty performance final level/initial level – 1 Fixed coupon 26.70% Participation rate (variable component) 85%Coupon payoff – If Final Level >= Initial Level, Principal + Max FixedCoupon, Participation rate * Nifty Performance) Else, If Final Level < Initial Level; Principal + FixedCoupon. 
Conclusion –
This is a likely condition. Here the coupon payoff is a combination of the fixed and variable part (Directly depending on the performance of nifty) 
5.  NIFTY 50  If Final Fixing Level <= 25% of Initial Fixing Level: 0.000% If Final Fixing Level > 25% of Initial Fixing Level: 7.4273% p.a. (XIRR 6.95% p.a.)Suppose, Initial level (NIFTY 50) index = 9106.25 25% of initial level (NIFTY 50) = 2276.56 So, if the final fixing level is above a value of 2276.56, then coupon pay off will be 6.95%. 
Conclusion –
This condition is highly unlikely to happen. Looking at past trends, the probability that NIFTY 50 would fall below the level of 2376.56 is very low. 
6.  Gsec  If Final Fixing Level >=25% of the Initial Fixing level, then coupon+ principal If Final Fixing Level < 25% of the Initial Fixing level, then only principal. 
Conclusion –
This condition is highly unlikely to happen. Looking at past trends, the probability that Gsec would fall below 25% of the initial level is low. 
7.  10year Gsec  Underlying performance Final level/ Initial level * 100 Coupon payoff If UP >= 75% of initial level 8.45% If UP < 75% but >= 25% of initial level, then 8.40% If UP < 25%, then 0. 
Conclusion This condition is highly unlikely to happen. Looking at past trends, the probability that Gsec would fall below 25% of the initial level is low. Also, the difference between the two coupon rates is 0.5% 
8.  NIFTY 50  Reference IndexLinked Return= Debenture Face Value* Reference Index Return FactorFactor = Max [0%, 115%* {(Observation Value of the Reference Index / Start Reference Index Value) – 100%}] 115% is the participation rate Observation Value of the Reference Index shall Mean Closing Value of CNX Nifty on the scheduled valuation date for redemption. 
Conclusion– This condition is likely to happen since the return is directly dependent on the performance of the index.Here, the value of Nifty for example is 5700, if nifty falls below 5700, there will be 0% pay off, if nifty rises above 5700, then the payoff would be 115% of the performance of NIFTY, For example, if Nifty is 5700 and it rises to 6000 rise is 5% coupon payoff shall be 115% of 5% = 6.05%. 
9.  Gsec  If the performance of underlying final fixing date –
greater than 50% of digital level : Coupon= 8.6819 p.a. *Digital level: 100% of the Closing price of the reference security, of 7.17 GSec 2028 as on Initial Fixing Date. 
Conclusion– The condition is unlikely to happen. E.g. The Value of Gsec on the initial date is 97. 72 The chances that the same will fall below 48.86 is very low. 
10.  NIFTY 50  If Final Fixing Level <= 25% of Initial Fixing Level: 0.000% If Final Fixing Level > 25% of Initial Fixing Level: 8.70% p.a. (XIRR 8.35% p.a.)Suppose, Initial level (NIFTY 50) index = 9106.25 25% of initial level (NIFTY 50) = 2276.56 So, if the final fixing level is above a value of 2276.56, then coupon pay off will be 6.95%. 
Conclusion –
This condition is highly unlikely to happen. Looking at past trends, the probability that Nifty 50 would fall below the level of 2376.56 is very low. Further, put option is given participation rate is lower i.e. 65%. 
11.  NIFTY 50  Coupon amount –
A) If Final > 140% of Initial, then coupon rate =Performance% of the initial principal amount 
Conclusion –
This condition is highly unlikely to happen as the possibility of Nifty falling to 40% is rare. 
12.  NIFTY 50  Coupon = Max(Underlying Performance, Min(48.85%,Max(4.885*Underlying Performance,0)))Underlying performance – (Final Fixing Level / Initial Fixing Level) – 1 
Conclusion –
The condition is likely to happen. 
13.  Gsec  If Final Fixing Level <= 25% of Initial Fixing Level: 0.000% If Final Fixing Level > 25% of Initial Fixing Level: 6.80% p.a.Suppose, The initial level of gsec is 100 25% of initial level (G Sec) = 25 So, if the final fixing level is above a value of 25 then the coupon payoff will be 6.80%. If the final fixing level is below 25, the coupon will be 0%. 
Conclusion –
The condition is highly unlikely. Looking at past trends, the probability that gsec will fall to 25% is very low. 
14.  Nifty 10 YR Benchmark GSec (Clean Price) index  100% of Principal Amount * (Coupon A + Coupon B) Where,
“Coupon A” shall mean: Or B) If Final Level < 30% of Initial Level (i.e. 0.30 * Initial Level), “Coupon B” shall mean: (1 + Coupon A) * 10.50% * (DayCount/365) Suppose, So, if the final fixing level is above a value of 277.5 then coupon pay off will be 21%. 
Conclusion –
The condition is highly unlikely. Looking at past trends, the probability that gsec will fall to 30% is very low. 
15.  NIFTY 50  If Final Fixing Level >=25% of the Initial Fixing level = 36.405% If Final Fixing Level < 25% of the Initial Fixing level = 0%Suppose, Initial level 10710.45 final below 2677.61 only then will the coupon be 0%. 
Conclusion –
The condition is highly unlikely. Looking at past trends, the probability that Nifty 50 will fall to 25% is very low. 
16.  CNX Nifty  Here, the entry NIFTY is calculated as average for 3 dates in 3 months.
For the final level NIFTY on 11 observation dates is calculated. Increases have been divided into levels – and for each level, there is a percentage for coupon rate. The highest coupon rate out of all the 11 levels will be taken for the final coupon rate. The minimum level is 115% of the entry Nifty. Below that no level and no coupon. 
Conclusion – The coupon is based on the performance of Nifty and hence is likely to happen. 
17.  10 year Government security price  (a) if IGB 5.79 05/11/30 Corp Price => 75% of *Digital Level the Coupon rate shall be at 11% p.a. (Maximum)
b) if IGB 5.79 05/11/30 Corp Price is less than 75% but equal to or greater than 25% of *Digital Level the Coupon rate shall be at 10.95% p.a. (Minimum) (c) if IGB 5.79 05/11/30 Corp Price < 25% of *Digital Level then no Coupon shall be *Digital Level – 100% of IGB 5.79 11/05/2020 Corp price at Initial Observation Date. 
Conclusion –
As such it’s highly unlikely to receive no coupon at all as the probability of the gsec falling to 75% is negligible looking at the past trends. Even the probability of the Gsec value falling between 25 – 75 % is unusual, but even if it does, the difference is the coupon rate is merely that of .05% which is negligible. 
18.  CNX Nifty  If Final Fixing Level >=25% of the Initial Fixing level = 32.143% If Final Fixing Level < 25% of the Initial Fixing level = 0%Suppose, The initial level is 10252.10 If the final level falls below 2563.03 then the coupon rate will 0 and above that coupon rate will be 9.25%. 
Conclusion –
The condition is highly unlikely. Looking at past trends, the probability that Nifty 50 will fall to 25% is very low. 
Analysis of the MLD market in India
On an analysis of the cases given above, one can clearly observe that the conditions on which the performance of the underlying is based, are highly unrealistic. An instance where the value of Nifty or a Gsec would fall by 5075% seems quite impossible where even ‘The Great Depression of 2008’ caused a fall of only 40% in stock indices. Hence in almost all conditions, the investor will always be receiving a coupon and thus the hedging shown is more of a hoax. The MLDs are, thus, not marketlinked at all thereby defeating the purpose of introducing MLDs. On lifting the veil of the underlying condition used, it reveals that the MLDs are in fact equivalent to plain vanilla debentures.
Conclusion
The true intent and spirit of introducing the concept of MLDs can be seen missing from a lot of the issuances by the companies. Instead, MLDs, are being issued, rather in some of the most farcical avatars, to gain regulatory arbitrage otherwise not available to plain vanilla debentures. This is indicative of what the market perceives as a bottleneck or a disadvantage, and what the market desires.
This, in itself, may call for a relook at the extant regulatory framework. Relaxations or exemptions should be considered where laws are not meeting the requisite purpose or are harsher than required, except where such relaxations become unconscionable or go against the basic tenets of policymaking.
Leave a Reply
Want to join the discussion?Feel free to contribute!