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Many risks in Nifty-linked debentures you don't recognize

On the face of it, structured products like nifty-linked debentures appear to be a brilliant product...
... if the market goes up, you are entitled to the gains
... if the market falls, your capital is returned intact.

In other words, while the downside is protected (called capital-protection in financial jargon), you make money on the upside.

However, as I had explained earlier, nifty-linked debentures are more hype than substance.

And, before you commit your money to such schemes you need to know the answer to the question Do I put my money in Capital Protection Schemes?

Let me now elaborate more on the "risks" that accompany such financial products.

1. The biggest risk is that your gains are capped. Typically, you will get the profits only till a certain pre-specified level of Nifty. The moment this limit is breached, your returns are freezed. You won't enjoy the benefits of any further appreciation in the Nifty beyond these levels.

2. Effectively speaking you are "lending" money to a finance company. Therefore, you are open to the default risk. If anything goes wrong and the company is unable to return your money, you have no recourse except a legal case. This, given the Indian scenario, is no real protection against defaults.

3. Remember, it's a loan. So the gains are treated as "interest" income, which means that every rupee you earn is fully taxable (30% in most cases, as this product is primarily for the high net-worth individuals.)

4. Liquidity is practically non-existent. Though listed on the stock exchange, you can't really sell it as hardly any trading happens in these debentures. You have to wait until maturity (normally 3 to 5 years) for the company to redeem the debentures and return your money.

5. The capital protection works only if you hold the investment till maturity. So, even if you are able to find buyers on the stock exchange, you could suffer a loss depending on the market conditions then prevailing.

6. Even when your capital is protected, should the market suffer a depreciation, you would lose interest that you could have otherwise earned. One should take this opportunity lost too into consideration.

7. It typically comes with higher charges and payable upfront. Instead, if you were to create your own 'hybrid' product (these nifty-linked debentures too have a equity-debt mix), you would not only save on these so-called "structuring" expenses, but also enjoy better tax-efficiency.

Given this 'reality-check', you are now more informed about such structured products and as such you can now take a more informed investment decision.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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