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- Equity-linked notes (ELNs) mix bonds and equities, offering higher returns with possible principal protection.
- Returns depend on equity performance, participation rate, and the issuer’s structure choices for equity-linked notes.
- Risks with ELNs may include loss of principal, market swings, low liquidity, and issuer default.
What is an equity-linked note?
An equity-linked note (ELN) is type of debt instrument similar to a bond that pays returns based on the performance of its underlying assets. Banks or financial institutions issue ELNs with a specific maturity date. An ELN may be principal-protected with a zero-coupon bond. This means investors won’t lose their principal investment. A zero-coupon bond is a bond that doesn’t offer interest during its life but is sold at a discount to its face value.
How equity-linked notes work
In general, an ELN has a bond component and equity options. The issuer may spend some portion of the ELN to buy a zero-coupon bond to ensure the 100% return of the principal at maturity. The remaining amount is used to purchase equity.
If equities perform well, the returns are shared with the investors. However, only the principal is returned if the underlying assets perform poorly.
If the issuer does not buy a zero-coupon bond, they may offer the investor a participation rate, promising to share a percentage of the returns from the overall performance of the underlying assets.
For example, if the participation rate is 80% and the underlying assets provide 10% returns at maturity, the investor receives their principal plus 8% (80% of 10%) of the underlying equity options’ overall returns. However, if the underlying equity undergoes a loss at maturity, you may lose your principal.
Benefits of equity-linked notes
Equity-linked notes come with several benefits as compared to other fixed income securities and may be better suited for risk-averse investors.
Opportunities to earn better returns
With investments tied to the underlying equities, ELNs offer higher returns that can pay more than fixed-income opportunities.
Lower risk
ELNs have a lower risk due to principal protection. If the issuer has ensured the principal with a zero-coupon bond, the principal is returned in full.
Short term
ELNs are short-term investments held for 1-4 months , ensuring you can receive the returns quickly and reinvest in other profitable investment options.
Flexibility
Equity-linked notes offer investors the option to choose their preferred underlying equities or stocks.
Risks with equity-linked notes
Like any other investment vehicle, ELNs carry some risks that investors should be aware of.
- Principal risk: Some issuers may not provide principal protection and instead offer returns based on the participation rate and the performance of the underlying equity. If the underlying equity performs poorly, the principal is lost, and there may be no returns.
- Market risk: Since the underlying equity determines the final returns, market volatility can affect ELN returns.
- Liquidity risk: ELNs have a certain maturity date, which makes them less liquid. If an investor wants to withdraw before maturity, it can be done at a discounted price, causing a loss.
- Issuer default risk: This is the risk associated with the ELN provider. The issuer may default on its obligations; if that happens, the investor may lose all their investment.
- Opportunity cost: ELNs only pay out on maturity, so there is an opportunity cost if they only pay the principal.
Who are equity-linked notes for?
Equity-linked notes may be a smart choice for investors in bullish markets, especially those seeking higher returns compared to fixed income securities. They may be a good fit for risk-averse investors who want to benefit from market trends without losing their initial investment. That said, ELNs can be complex with different features and fees. It’s important for investors to fully understand the product before investing. Consider reaching out to a financial advisor for more information.
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