Equity-Linked Notes: Diversify Your Portfolio And Reduce Risk

Equity-linked notes (ELNs) are a type of structured product that combines the features of a bond and an option. They are a complex financial product that offers investors exposure to the equity market while providing the safety of a fixed-income instrument. ELNs are typically issued by financial institutions and are a type of debt security. They have two main components: a bond component and an equity option component. The bond component provides a guaranteed minimum return, while the equity option component allows investors to participate in the potential upside of the equity market. ELNs offer several benefits, including the potential for higher returns and lower risk due to principal protection. However, they also come with risks, such as the performance of the underlying equity and issuer default.

Principal protection

100% Principal Protection

ELNs are designed to provide 100% principal protection at maturity, meaning that an investor's initial investment is guaranteed, regardless of the performance of the underlying equity. This is often referred to as a principal-protected note (PPN) or guaranteed linked note. The return of principal is guaranteed by the issuer, in addition to any gains resulting from the formula based on the performance of the underlying equity.

Zero-Coupon Bond Component

The bond component of an ELN is typically a zero-coupon bond, which does not pay interest during its life. Instead, it is sold at a discount to its face value and pays the full face value at maturity. This component guarantees the investor's principal investment, assuming the issuer does not default.

Long-Term Maturities

ELNs tend to have long-term maturities, which can range from a few years to a decade or more. This means that investors must be prepared to tie up their funds for long periods of time. Early withdrawals may be subject to withdrawal charges, and partial withdrawals may reduce the amount available upon full surrender.

Creditworthiness of the Issuer

It is important to note that the guarantee of principal protection is only as good as the creditworthiness of the issuer. In the event that the issuer goes bankrupt, investors may lose their entire investment. Therefore, investors should carefully consider the creditworthiness of the issuer before investing in an ELN.

Suitability for Risk-Averse Investors

ELNs are well-suited for risk-averse investors who wish to protect their principal investment while still participating in gains from favourable market movements. The potential for unlimited upside returns with limited downside risk makes ELNs attractive to those with a bullish outlook on the market but who are cautious about potential losses.

Comparison to Traditional Bonds

While ELNs offer principal protection, they may also come with the trade-off of lower returns compared to traditional fixed-income instruments. ELNs may earn no return for the entire term of the note, even if held to maturity. Additionally, there is an opportunity cost associated with locking in funds in an ELN, as the money could be invested elsewhere.

Higher returns

Equity-linked notes (ELNs) offer the potential for higher returns compared to traditional fixed-income instruments. This is because the return on an ELN is linked to the performance of the underlying equity. If the equity performs well, investors can earn a higher return than they would from a traditional bond. This makes ELNs attractive to investors who are bullish on the equity market and want to maximise their profits.

The potential for higher returns is one of the main attractions of ELNs. The return on an ELN is determined by the performance of the underlying equity. If the equity performs well, investors can earn a higher return on their investment. This is because ELNs are linked to equities, which have historically outperformed fixed-income investments. As a result, investors in ELNs have the opportunity to earn higher returns compared to traditional bonds, guaranteed investment certificates, or fixed deposits.

The upside potential for returns in an ELN is theoretically unlimited, while the downside risk is capped. Even in the worst-case scenario, most ELNs offer full principal protection. This combination of high return potential and limited risk makes ELNs appealing to investors who want to maximise their profits while minimising their risk.

However, it's important to note that the potential for higher returns comes with a higher risk. If the underlying equity performs poorly, investors may only receive the return from the bond component, which could be lower than what they could have earned from a traditional bond. Therefore, investors need to carefully consider the characteristics of the underlying equity and their own risk tolerance before investing in ELNs.

Additionally, ELNs typically have higher fees and built-in costs compared to traditional investments. These fees can impact the overall return on investment. Therefore, investors should calculate these costs before investing in ELNs.

Customised investment choices

Equity-linked notes (ELNs) are highly flexible and customisable. They allow investors to choose the underlying assets they want to link to the notes, such as stocks, shares, securities, or a broader market index. This flexibility enables investors to create wealth baskets tailored to their risk tolerance and income-earning objectives.

The customisation of ELNs extends to determining the number of shares or securities linked to the notes. This feature ensures that investors can design structured products that align with their specific risk profiles and financial goals. For instance, investors can opt for a principal-protected ELN, which guarantees the return of their initial investment, making it attractive to risk-averse individuals. Alternatively, non-principal-protected ELNs expose the investor's capital to market volatility, offering the potential for higher returns.

The dynamic nature of ELNs, deviating from the fixed-interest model, is another aspect that caters to diverse investor preferences. The interest rates of ELNs are linked to the performance of the equity markets, resulting in variable returns. This dynamic structure adds complexity to an investor's strategy and can be particularly appealing to those seeking higher returns.

The ability to customise ELNs makes them a versatile investment tool, allowing investors to balance risk and return while improving their risk tolerance and catering to specific income objectives. By offering customisation options, ELNs empower investors to make informed choices based on their financial goals and risk appetite.

Exposure to the equity market

Equity-linked notes (ELNs) provide investors with exposure to the equity market. This can be beneficial for investors who want to diversify their portfolio or who believe the equity market will perform well. By investing in an ELN, investors can participate in the potential upside of the equity market without having to directly invest in equities.

ELNs are a type of structured product, a financial instrument that has been engineered to produce specific risk and return characteristics. The return on an ELN is linked to the performance of a single equity security, a basket of equity securities, or an equity index. The underlying stocks typically have large market capitalisations.

The note's lifespan typically ranges from a few years to a decade, and at maturity, the investor receives a return based on the performance of the underlying equity. ELNs are usually held until maturity instead of being traded on the secondary market.

The two main components of an ELN are a bond component and an equity option component. The bond component provides the investor with a minimum guaranteed return, while the equity option component allows the investor to participate in the potential upside of the equity market.

The bond component of an ELN is typically a zero-coupon bond, which is sold at a discount to its face value and pays the full face value at maturity. This component guarantees the investor's principal investment, assuming the issuer does not default.

The equity option component of an ELN is a call option on an equity or a basket of equities. A call option gives the holder the right, but not the obligation, to buy an asset at a specified price within a specific time period. This component gives the investor the potential to earn a higher return if the underlying equity performs well.

When an investor purchases an ELN, the issuer uses the invested capital to purchase a zero-coupon bond. The remaining funds are used to purchase call options on the underlying equity. The number of options purchased depends on the amount of capital remaining and the cost of the options.

At maturity, if the underlying equity has performed well, the investor receives the return from both the bond and equity option components. If the equity has performed poorly, the investor only receives the return from the bond component. This structure allows the investor to participate in the potential upside of the equity market while limiting their downside risk.

Dynamic in nature

Equity-linked notes (ELNs) are dynamic in nature, offering investors a versatile tool to balance capital protection with potential returns linked to equity performance. This dynamic nature stems from the ability to customize ELNs to align with specific financial objectives and market conditions.

One aspect of their dynamic nature is the flexibility in structuring. ELNs can be tailored to meet investors' risk-return objectives and their views on specific sectors or the market as a whole. For instance, an investor bullish on the technology sector can structure an ELN linked to a basket of tech stocks, allowing them to participate in the sector's growth while safeguarding their principal investment. Similarly, investors seeking international exposure can create ELNs tied to global equity indices, providing diversification and potential for worldwide growth.

The dynamic nature of ELNs also lies in their ability to adapt to different market scenarios. For instance, during periods of market volatility or uncertainty, investors can structure ELNs to provide downside protection while still capturing potential upside. Additionally, ELNs can be designed to hedge against currency exchange rate fluctuations, making them valuable for global investors or corporations with international operations.

Furthermore, ELNs offer dynamic hedging strategies. Instead of using options, some ELNs employ dynamic hedging techniques, leveraging the underlying equity to enhance returns. This approach allows investors to actively manage their risk exposure and maximize potential gains.

The versatility of ELNs extends to their application in retirement planning and corporate risk management. In retirement portfolios, ELNs can provide enhanced returns while preserving capital, catering to the need for both growth and security. Corporations also use ELNs to manage specific risks, such as currency exchange rate fluctuations, by creating ELNs tied to relevant currency pairs.

In summary, the dynamic nature of ELNs stems from their customizability, adaptability to market conditions, hedging strategies, and versatility in real-world applications. This flexibility allows investors to align their investments with their financial goals and market outlook while managing risk exposure.

Frequently asked questions