What Are Equity-Linked Notes (ELNs)?
An equity-linked note (ELN) is an innovative investment product that merges the stability of a fixed-income investment with the additional return potential tied to the performance of equities. Generally, ELNs are designed to return the initial capital along with a variable interest determined by the linked equity’s performance. They can be tailored in numerous ways but usually involve elements like a strip bond paired with a call option on a specific security, a collection of securities, or an index like the S&P 500. For notes linked to equity indices, terms such as equity index-linked notes are commonly used.
Understanding Equity-Linked Notes
Equity-linked notes are appealing because they provide potential for higher-than-average returns compared to traditional bonds while still protecting the invested capital. Even in the worst-case scenario, ELNs generally offer full principal protection, making them ideal for risk-averse investors with a bullish market outlook. However, since ELNs only pay returns upon maturity, there is an opportunity cost associated with locking in your money if only the principal is eventually returned.
How ELNs Work
Consider a simple example: a $1,000, 5-year equity-linked note might allocate $800 to purchase a 5-year strip bond with a 4.5% yield-to-maturity. The remaining $200 could be invested and reinvested in call options on the S&P 500 throughout the note’s 5-year duration. If the options expire worthless, the original $1,000 principal is returned to the investor. However, if the options gain value based on the performance of the S&P 500, the investor receives these added returns along with the original investment.
Key Features of ELNs: Caps, Participation Rates, and Leverage
Equity-linked notes typically come with a participation rate, which dictates what percentage of the underlying equity’s appreciation the investor will benefit from. For instance, if the participation rate is 100%, a 5% increase in the underlying results in the same increase for the investor’s note payout. However, costs linked to structuring and managing ELNs may lower this rate. A 75% participation rate would mean a 5% appreciation in the underlying equity translates to a 3.75% increase for the investor.
ELNs can vary significantly. Some feature an averaging formula to smooth returns from the equity-linked portion, while others use periodic caps that limit potential upside but ensure gains are realized at a particular level regularly. Additionally, certain ELNs incorporate dynamic hedging and leverage to amplify returns from the underlying equity. These versatile characteristics make ELNs a compelling option for investors seeking principal protection combined with the growth potential of an equity investment.
Related Terms: strip bond, call option, equity index-linked note, participation rate, risk-averse.
References
- Financial Industry Regulatory Authority. “Structured Notes With Principal Protection: Note the Terms of Your Investment”.
