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Analyse equity-linked debentures carefully

Several new types of instruments are present in the capital market today. One of these are equity-linked debentures that are slowly finding their way indirectly into investors’ portfolio because of their holdings by some mutual fund schemes.

business Updated: Sep 21, 2008 20:21 IST

Several new types of instruments are present in the capital market today. One of these are equity-linked debentures that are slowly finding their way indirectly into investors’ portfolio because of their holdings by some mutual fund schemes.

Many high net worth individuals hold these instruments directly and in many cases investors do not even know the nature of such instruments. These are often quite complex to understand and hence investors need to understand the exact nature and features of this instrument.

Nature
Equity-linked debentures are, as the name suggests, debentures that are available for investment. Unlike normal debentures, which offer only payment of interest to the holder, equity linked debentures give returns that are linked to some equity benchmark usually an index. This means that the return figure will change depending upon the position of the equity-linked feature.

If this has done well then there will be a higher return coming in and thus the investor actually gets an exposure to equity returns even without actually buying equity.

Safety-net
There is an element of protection as far as returns are concerned. Since there is an equity link involved the position can move either ways. If there is a fall, the price can go below the price that they started out with.

In such a case the instrument provides an element of safety for the investor because there will not be any loss of capital and the basic amount will be protected. This becomes a bit of a relief especially in uncertain times when things can change quickly and price movements can be on either side.

Cap on returns
These debentures often offer a cap on returns that the investor will generate from the upside of equity. Thus it can be fixed that if the equity rises 30 per cent or 35 per cent from the level they started out with, then there will be a fixed 15-20 per cent return on the bond.

This will ensure that there is a cap set on the upside for the instrument and the investor will not be able to participate to the full extent of the rally especially when there is a strong bull market and the prices have risen quite high. This factor also needs to be taken into consideration by the investor when they are making their decision to buy this instrument.