This debt option offers high returns & capital preservation. Too good to be true?

When markets get tough, MLDs (market-linked debentures) get going. Or at least that's what wealth and relationship managers say.

The sales pitch is that MLDs offer the best of both worlds. In a bearish scenario, they preserve your capital; in bullish times, they provide equity-like high returns, though there's a ceiling on how much you can earn.

Let's consider one of the current MLDs promising 1.5 times the returns of its underlying index over two years. If the index grows 22 per cent, the investor stands to gain 33 per cent over two years. That's the most an investor can earn. Even if the index rises 50 per cent, the investor still earns 33 per cent.

Conversely, if the underlying index goes red, the investor can recoup at least their original investment.

But it's not all hunky-dory.

While they can grow your wealth by 33 per cent, these are absolute returns over two years. The annual returns are far more modest, at around 15.3 per cent.

In other words, the maximum you can earn through an MLD is 15.3 per cent, regardless of how well the index performs.

That's not all. There are a few more chinks in their armoury.

• An expensive foray: For starters, you need at least a lakh to invest in these debt securities.
  
  That's right, they are debt securities. Think of MLDs as a type of loan that you give to companies or financial institutions, not directly but through what's called a private placement. Financial institutions mainly use the funds to provide further loans to private companies. This loan taken by financial institutions lasts for about 1 to 5 years.
• A run for your refund: MLDs can be risky. Since a significant portion of the funds is loaned to private companies with poor credit ratings, there is a higher probability of a default. If that happens, you may need a prayer on your lip to get back your original investment.
  
  Also, while most of these securities are principal-protected MLDs, you may unwittingly find a few unprotected ones that offer no guarantee of the initial investment.
• Tax terror: The taxman is pretty severe, too. Unlike in the past, when long-term capital gains were taxed at a favourable 10 per cent rate, earnings from MLDs now fall under the investor's regular income tax slab, irrespective of the holding period. So, if you fall in the 30 per cent tax bracket, your gains are taxed at a similar rate as well.
  
  Worse, there's a 10 per cent tax on interest income. This is deducted at the time of receiving the income.
• Not a part of long-term plans: Although the best-sky scenario is earning around 15.3 per cent returns annually, the relatively short maturity periods of MLDs, typically around two years, make them challenging to fit into long-term financial planning.

Our take

As mentioned earlier, MLDs are a debt option. This is not a world where you chase returns. That's because seeking higher returns means you have to take higher risks. And the essence of debt investments is stability and capital preservation. Not risk.

If you must take risk, look towards equity and equity-oriented investments.

What you should do

Aggressive hybrid mutual funds are a better option for an investor seeking a balance of safety and market exposure over at least five years.

Not only has a middling aggressive hybrid delivered 16.2 per cent returns over three years, more than MLDs' best-case scenario of 15.3 per cent, it also offers a blend of stock market participation and downside protection.

What's more, these funds are treated as equity investments for tax purposes, making them more tax-efficient than MLDs. In other words, even a middling fund's post-tax returns have also been higher.

Also read: Solution-oriented funds and their exit load