Demystifying Structured Debt Securities: Beyond Plain Vanilla Bonds

Palak Jaiswani, Manager | corplaw@vinodkothari.com

Debentures, one of the most common means for raising debt funding, where investors lend money to the issuer in return for periodic interest and repayment of principal at maturity. While the basic feature of any debenture is a fixed coupon rate and a defined tenure (commonly referred to as plain vanilla instruments), sometimes these instruments may be topped up with enhanced features such as additional credit support, market-linked returns, convertibility option, etc., thus referred to as structured debt securities.

Structured debt securities: motivation for issuers

Apart from the economic favouring such structural modifications, a primary motivation for the issuer in issuing such structured instruments might be the regulatory advantages that these securities offer. For instance,

• Chapter VIII of SEBI NCS Master Circular provides an extra limit of 5 ISINs for structured debt securities & market-linked securities, thus more room for the issuers to issue debt securities, compared to the restriction of a maximum of 9 ISINs for plain vanilla debt.
• In addition, as per NSE Guidelines on Electronic Book Provider (EBP) mechanism, market-linked debentures are not required to be routed through EBP, allowing issuers to place such instruments almost like an over-the-counter trade. This allows issuers to structure the debt securities on a tailored basis and offer them directly to specific investors.

Why do investors choose to invest?

As discussed above, structured debt securities primarily distribute the risk or rewards among the parties involved. Such securities are designed according to the needs of a specific set of investors. For instance, investors with a high risk appetite and expecting a higher yield than plain debt or equity may lean towards equity-linked instruments. On the other hand, investors with a conservative approach may opt for credit-backed debt securities.

What makes a debt security a structured debt security?

In a plain debt security, the issuer agrees to pay a fixed rate of interest for a defined period of time and return the principal at maturity. When such simple debt security is designed or customized with add-in conditions or features, which results in distributing the risk-reward amongst the parties involved, it becomes a structured debt security.

International Monetary Fund, in its Handbook on Securities Statistics^[1], defined the term ‘structured debt security’ as a combination of a debt security, or a basket of debt securities, with a financial derivative, or a basket of financial derivatives. These financial derivatives are typically embedded and therefore inseparable from the debt securities.

To understand the meaning of ‘debt security’ one can refer to Reg. 2(1)(k) of SEBI NCS Regulations, which defines the term as a non-convertible debt securities with a fixed maturity period which create or acknowledge indebtedness and includes debentures, bonds or any other security whether constituting a charge on the assets/ properties or not, but excludes security receipts, securitized debt instruments, money market instruments. The term ‘financial derivative’ means such instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right.

Essentially, it is a debt instrument with embedded features to make it more complex than a conventional debt security. Such features may be in the form of an external benchmark or index, a credit-enhancing feature or a difference in payment priorities.

While the term is a combination of debt security and an underlying feature or condition, it is critical to understand what are these conditions or features which make a debt security a structured one.

1. An instrument deriving its value from an underlying asset or index;
2. Cash flows or returns on the instrument are dependent upon an underlying benchmark or index, such as equity market indices, prices of commodities, foreign exchange rates, etc.
3. An instrument involving additional credit support to make the instrument safer for investors, for e.g., guarantees, letter of credit, etc.

How are these different from plain vanilla?

The word ‘structured debt security’ is used in contradistinction from plain vanilla debt securities. The latter means a debt security where the principal and interest are both determinable and are unconditional obligations of the issuer. Neither is interest nor the principal is supported or credit enhanced by any other support, such as a guarantee. On the other hand, structured debt security is either linked with specific cashflows, specific assets, specific sources of repayment, specific investments or returns therefrom, or has linkage with credit default, market rates, etc. Hence, unlike plain vanilla bonds, the returns on structured debt securities are generally uncertain, contingent upon the happening or non-happening of conditions to which the instrument is linked to.

What are the types of structured debt security?

Let us better understand that with some of the most common types of structured instruments and their examples.

Market-linked Debentures (MLDs): Debt securities that have an underlying principal component and are issued with market-linked returns obtained through exposures on exchange-traded derivatives or MIBOR, GDP, inflation rate, underlying securities/ indices, etc. (As per Chapter X of SEBI NCS Master Circular). They are linked to the performance of an underlying index or security in terms of returns. If the underlying performs well, the return on MLDs is higher, while the return decreases when the underlying plunges. For e.g., coupon is linked to the movement of G-Secs yield or repo rate.

While MLDs have several sub-categories depending on the nature of the underlying index, such as G-secs, NIFTY index, etc., they are broadly classified into two types (i) Principal Protected, which promises the return of full principal at maturity; and (ii) Non-Principal Protected, where the return of principal is at the risk of downside performance of the underlying index. However, Non-Principal Protected MLDs are not covered under the SEBI NCS Regulations^[2].

Convertible Debentures: As the name implies, debt securities which may be converted into equity at a specified point in time. It is an instrument having a combination of both debt and equity, i.e., the debt later gets converted into equity upon the occurrence of certain events or after a certain period of time. For e.g., 4-year debenture convertible at equity at the end of 2nd year. Such debentures may be fully convertible, partially convertible or optionally convertible.

Debenture with credit enhancement:  It is a debt security having underlying credit support from an external party. It provides an assurance to investors indicating that the commitment will be fulfilled through support from external security, such as collateral, a guarantee, etc. For e.g., instruments backed by a partial credit guarantee by a third party or by a letter of credit.

Subordinated Debentures: Debt securities which have lower priority than other debt securities in terms of payment. The holders of these securities are paid after repaying the obligations of senior debt instruments. These securities are essentially unsecured and mostly issued by Banks and NBFCs to meet regulatory capital and funding requirements.

Does the call/put option make a debt security structured?

‘Call option’ is an option to buy something at a fixed rate even if the market rises, while ‘put option’ is an option to sell something at a fixed price even if the market declines^[3]. In the context of debentures, a put option would put an obligation upon the issuer to repay the investor as and when the investor ‘puts’ the security. On the other hand, a call option would enable the issuer to prepone the date of the redemption of debentures by ‘calling’ the debentures from the investor.

Regulation 15 of SEBI NCS Regulations also defines the call and put option in context of listed debt security and provides conditions for exercise of such options:

“(1) An issuer making issuance of non-convertible securities shall:

(a) have the right to recall such securities prior to the maturity date (call option); or,

(b) shall have a right to provide such right of redemption of debt securities prior to the maturity date (put option) to all the investors or only to retail investors.”

As is generally understood, a call option might be economically useful for issuers for several reasons, e.g. refinancing by calling back fixed rate debentures where there has been a decline in the interest rates; scaling down the long-term liabilities which are no more needed; utilising instantly available cash surplus, which might not be available in future for expected/projected cash outflows, etc. A put option might be more beneficial for investors, giving them an extra cushion of comfort to sell the debt security before the maturity date to manage their risks, such as interest rate risk or default risk.

One pertinent question here arises as to whether the embedded call or option makes the debt security as structured debt security and why is it so relevant for the debt issuer? The answer is the ISIN level restrictions (as discussed) for issuance of listed debt securities. An appropriate classification based on the features is important for an issuer to ensure adherence with the limits, as the structured debt securities have a stricter cap limit of 5 ISINs per financial year.

The mere existence of a call option or put option does not amount to a structured debt security. The obligation is still that of the issuer, and is unconditional and unsupported. Call option serves to potentially contract the maturity at the option of the issuer, whereas put option may contract the maturity at the option of the investor. Therefore, we can say that callable or puttable options are linked to the maturity of the debt security, however, such an embedded option does not impact the unconditional obligation of the issuer to pay, making them plain vanilla debt security. Thus, in the absence of any other linkage to the payment or servicing obligation, in our view, the mere existence of a call or put option does not make a debt obligation a structured debt security.

Do tax implications of MLDs apply to all forms of structured debt?

MLDs became a popular mode of fundraising not only due to their unique structure offering market-linked returns but also because of the tax arbitrage they provided. Historically, MLDs were exempt from withholding tax and enjoyed concessional LTCG tax at 10%, provided the instruments were held for a minimum period of 12 months. However, the Finance Act, 2023, significantly altered the tax landscape for MLDs. Through the introduction of Section 50AA of the Income Act, 1961, gains arising from the transfer of MLDs are now taxed at the investor’s applicable slab rate, regardless of the holding period.

However, does such tax treatment also apply in case of other structured debt securities? As per Section 50AA, MLDs means a security by whatever name called, which has an underlying principal component in the form of a debt security and where the returns are linked to market returns on other underlying securities or indices and include any security classified or regulated as a market linked debenture by the SEBI.

While SEBI defines the term MLDs (mentioned above) it does not specifically define the term ‘structured debt security’ separately. However, the same has been used interchangeably by SEBI. A reference to the term ‘structured debt security’ was provided in SEBI Circular dated September 28, 2011 (now updated and subsumed in Chapter X of SEBI NCS Master Circular), which introduced the framework on market-linked debentures. As per para 4(a), the aforesaid circular applies to ‘structured products’ or ‘market-linked debentures’, by whatever name they are called including all such securities that have an underlying principal component in the form of debt securities and where the returns are linked to market returns on other underlying securities/ indices. For a detailed discussion on taxation on MLDs, read our article here.

However, note that MLDs are a subset or category of the broader concept of structured debt. The feature that makes MLD a structured debt is the underlying benchmark for principal & returns; however, structured debt is designed with payments linked to specific cash flows, underlying assets, sources of repayment, or investments, or they may be connected to credit events, market rates, or other defined benchmarks. Hence, the tax treatment pursuant to section 50AA, as applicable to MLDs, cannot be said to be applicable to all forms of structured debt securities.

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^[1] Version dated May, 2009

^[2] As per para 2.1 of Chapter X of SEBI NCS Master Circular

^[3] As per Black’s Law Dictionary 8th Edition – Page 1128

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Read our other articles on the matter:

1. Market Linked Debentures: Adding flavour to plain vanilla bonds
2. SEBI further caps limit for ISINs to reduce fragmentation and boost liquidity