An equity-linked note (ELN) refers to a debt instrument that does not pay a fixed interest rate. Instead, it is a type of structured product whose return is linked to the performance of its underlying equity. The equity tied to an equity-linked note can be a security, a basket of securities, or a broader market index.
An ELN differs from standard fixed-income securities, which are debt instruments that offer a fixed amount of interest on a fixed schedule to investors.
An equity-linked note (ELN) is a type of structured product where its return is linked to the performance of its underlying equity.
The features of equity-linked notes include principal protection, leverage employment, and higher total return potential.
Before investing in ELNs, it is important to assess all the benefits and risks.
Features of Equity-Linked Notes
Equity-linked notes are essentially debt instruments that are split into their principal and interest components. For the principal component, a typical ELN is principal protected. It usually consists of a zero-coupon bond that is paid upon maturity.
It means that the investor will be guaranteed to receive the original amount invested. In relation, ELNs offer investors some exposure to equity markets, while also offering a safety net by ensuring principal repayment.
An equity-linked note does not offer a fixed interest rate or yield to maturity. Hence, the interest component is staked in equity options. When the note matures, the final payout to investors will amount to the original principal plus whatever the payoff is on the equity options. Equity-linked notes are also short-term investments, typically 1-4 months in term length. Most ELNs are held until maturity instead of being traded on the secondary market.
Growing significantly, the ELN market now offers many features that appeal to different investor profiles. For example, a note that provides protection of the principal will attract investors that seek lower risk to their capital. A note that employs leverage will attract investors who seek higher returns.
Lastly, the total return potential of equity-linked notes will appeal to investors who seek alternatives to the low yields of fixed-income investments.
Benefits of Equity-Linked Notes
1. Opportunity to earn higher interest income
Investors want to invest in equities because historically, they’ve outperformed fixed-income investments. Equity-linked notes give the opportunity to earn higher returns in comparison to fixed-income investments, such as guaranteed investment certificates (GICs).
2. Lower risk due to principal protection
Most equity-linked notes provide a way for investors to protect their capital, and it is common for them to offer full principal protection. It is what makes ELNs appealing to risk-averse investors who want to explore equity markets with a safety net.
Equity-linked notes also offer investors the flexibility to choose their preferred underlying shares, index, or the number of shares.
Risks of Equity-Linked Notes
1. Market risk
The return of equity-linked notes is linked to the performance of underlying equity, which may fluctuate depending on market performance. It can adversely affect the value of the debt instrument. While notes are designed to reduce market risk, it is possible to lose a portion of the principal investment amount based on market performance.
2. Credit risk
Equity-linked notes are usually issued as unsecured debt obligations of a specific company. It means they are subject to that company’s trustworthiness. Should the issuer fail or default, investors may lose either all or part of their investment.
3. Liquidity risk
Liquidity is the ability for an investment to be readily converted to cash without a substantial discount. The secondary market for equity-linked notes is typically illiquid, as notes are designed to be held until maturity. The bid offers that do exist are often at a discount if companies decide to repurchase notes from investors.
Therefore, selling the note before its maturity date may result in a loss of capital. Investors should be prepared to stay invested until maturity; otherwise, they may incur a substantial loss in the principal investment amount.
4. Fees and taxation
As with any complex investments, there are many fees and built-in costs to ELNs. They include commissions paid to the issuing company and securities firm that sell the notes.
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