Eye on equity-linked debentures as volatility spikes in Indian markets

The Indian indices have entered bear market territory amid a spike in volatility.
Instruments whose payouts depend on equity market levels are likely to be closely watched amid the carnage in global and domestic markets.

The Indian indices have entered bear market territory amid a spike in volatility. The S&P BSE Sensex has fallen over 10,000 points from its peak. The India VIX, a volatility index which is also known as the market’s fear-gauge, has also risen to multi-year highs.

Ashish Shanker, associate director and head of investments for Motilal Oswal Wealth Management said equity-linked debentures will become more expensive for issuers now. Higher volatility increases the price of issuing such debentures since issuers typically hedge their risk using derivatives. The cost of such hedging goes up when volatility increases, making it less attractive for issuers who tend to prefer taking derivative positions to manage their risk.

“Most people will hedge,” he said.

Nimish Shah, head of investments at BNP Paribas Wealth Management said lower market levels make such instruments attractive from a return perspective.

“While this is the right time to get in (to such instruments), the credit risk and underlying business model of the issuing entity must be carefully evaluated,” he said.

Many issuers who are active in the market are rated ‘AA’ or below. This means that they carry a higher chance of default in the event of liquidity issues. Investors must weigh this risk when they decide to allocate capital to equity-linked debentures, he added.

Compiled by BS Research Bureau
Equity-linked debentures involve a payout which depends on market levels. This is usually achieved by investing a portion of the capital in call options. They give the investor the right but not the obligation to buy into securities at a pre-defined price. The issuer usually writes long-dated options for the investor depending on the maturity of the instruments. The interest on the debt portion covers the invested principal over the period of the instrument. The value of the call option provides an upside boost to returns.

The issuance of market-linked debentures, whose payout depends on a reference index, had been rising in recent times. They looked likely to hit a new high in 2019-20 (FY20), according to a June 25, 2019 report from rating agency Care, entitled Market linked debentures: Heading for a new high in FY20. Such issuances are likely to touch Rs 17,000 crore in FY20, according to the report.  

The National Stock Exchange’s Nifty 50 index accounted for 63 per cent of issuances for the quarter in which the report was issued. Many also have government securities’ movement as a reference. Issuers used the instrument to raise capital amid tighter liquidity conditions.

The average maturity of such issuances had fallen to 2.89 years in 2018-19 (FY19). It was 2.92 years in FY18.

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