What are Equity-Linked Securities (ELKS)?
Equity-linked securities (ELKS) are a type of debt instrument with unfixed payments that are linked to an underlying equity. They deliver the return of common shares in certain circumstances. ELKS are usually created as bonds by issuers as a capital financing method in private markets, which means investors cannot trade equity-linked securities in financial market exchanges.
- Equity-linked securities (ELKS) are a type of structured financial instrument with a return linked to a stock or a benchmark.
- If the underlying equity price remains above the predetermined downside threshold, the ELKS pay investors with fixed coupon payments during the term and the bond principal at maturity.
- If the underlying equity price goes below the predetermined downside threshold, investors receive the coupon return and the underlying equity return.
- ELKS provide upside potential and certain downside protection, but the risk of receiving less than the principal still exists.
How Does Equity-Linked Securities Work?
Equity-linked securities are a type of structured financial products that are combinations of more than one financial instrument and deliver returns of the combined instruments. ELKS share a few characteristics with both bonds and equities. Despite being in the form of debt, they generate returns impacted by the prices of the underlying stocks.
Typically, ELKS come with terms of maturity within one year and offer returns higher than both the dividend yields of equities and yields of vanilla bonds. They can be regarded as bonds with call options, which provide both principal protection and equity-linked returns.
A downside threshold price of the underlying equity is predetermined in ELKS. It is usually a discount of the equity price at the issuance of ELKS. Investors always receive fixed coupon payments during the term of the security regardless of where the equity price is. If the equity price remains above that predetermined level, investors will receive the repayment of principal at maturity. In this case, the security delivers the return as a bond.
For example, if an equity-linked security with a one-year maturity comes with a downside threshold of 90% of the equity price at issuance, which is $100, and an annual coupon of 8%. If the equity price remains above $90 during the entire term, investors will receive the 8% coupons and the bond principal at maturity. The total return is 10%.
Conversely, if the equity price goes below that threshold at any point before the security matures, the security will pay investors returns of the underlying equity. In this case, the security shows the characteristics of both bond and equity investment. The total return is the sum of the coupons paid and the return of the underlying equity at maturity.
In the same example above, if the equity price drops below $90 at some point during the term and then rises up to $110 at maturity, investors will receive a total return of 18% including the 8% of coupon return and 10% of equity return.
Types of ELKS
There are several types of ELKS. Depending on their issuers and equity types that they link to, there are three major categories: bank-offered ELKS, corporate ELKS, and market-linked securities.
1. Bank-Offered ELKS
Banks often offer ELKS investment opportunities to retail investors. For example, Citibank offers ELKS with maturities ranging from 6 to 13 months under its CitiFirst Performance Investments. Many ELKS are offered by banks alongside certificates of deposits (CDs) as equity-linked CDs. For example, Union Bank offers equity-linked CDs with 100% principal protection through its UnionBanc Investment Services.
2. Corporate ELKS
Corporates can use ELKS as a way of capital financing by working with investment banks for the issuance process. The ELKS are typically linked to the issuer corporates’ own common shares.
3. Market-Linked Securities
ELKS can be linked to a single stock or a market benchmark, which are thus known as market-linked securities. Such a type of ELKS offers exposure across industries with diversification benefits. Gold and currencies may also be the benchmarks for market-linked securities. Investors of gold-linked securities typically expect the same return as investing in gold directly.
Benefits and Risks of ELKS
With an upside potential and a certain amount of principal protection, ELKS enjoy the benefits of both equities and bonds. They offer period coupon income as bonds and potential for enhanced return through the option of equity. ELKS are particularly suitable for investors who are bullish on the equity market but at the same time looking for some downside protection.
Even though ELKS offer some downside protection, there is still a risk that the payment at maturity may be below the principal amount. Let us continue on the same example discussed above and come up with a third scenario:
The equity price goes below $90 during the term and ends up at $85 at maturity. In this case, what investors receive at maturity is only $85, lower than the bond principal. The total investment return is thus -7% with an 8% return from coupons and a -15% return from the underlying equity. There is still the possibility of losing in ELKS.
Another concern for ELKS investment is that these products are illiquid, as investors often cannot redeem or trade ELKS before maturity without triggering any penalties.
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