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

FY20 had seen increasing issuances on higher demand from issuers.

Instruments whose pay-outs depend on equity market levels are likely to be closely watched amid the carnage in global and local markets.

The Indian market saw its steepest fall in five years even as fears of coronavirus spreading continued amid a crash in crude oil prices. A price war roiled global oil markets as Saudi Arabia and Russia sparred over oil production. Saudi Arabia steeply cut oil prices and crude prices fell around 30 per cent. The S&P BSE Sensex was down 1,942 points (5.2 per cent) closing at 35,635.

Higher cost of issuing such debentures amidst such volatility is likely to weigh on issuances.

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

"Most people will hedge," he said.

The India VIX, a volatility index which is also known as the market’s fear gauge, surged by over a fifth on Monday.

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.