Equity-Linked NoteHetvi Shah
What is Equity-Linked Note (ELN)?
An Equity-linked Note is a structured debt instrument. It refers to an investment instrument that provides return linked to the performance of underlying equity instead of the fixed interest rate. The equity tied to an equity-linked note can be a single security, group of securities, or a broader market index. It differs from other debt instruments which provide fixed interest on fix schedule to the investors.
Get complete CFA Online Course by experts Click Here
Features of Equity-Linked Notes:
- Protection of principal: Equity-Linked Notes are split into Principal and Interest components. Usually, it consists of the zero-coupon bond which is paid upon maturity. It simply means that the investors will be guaranteed to receive the original amount invested. Thus, ELN is principal protected.
- Higher total return potential: Equity-Linked Notes, Usually, provides a higher return than the lower yields of fixed-income investments. Note employing leverage will attract investors who seek higher returns.
- Yield to Maturity: An equity-linked note doesn’t offer a fixed interest rate or fixed yield on maturity. When the note matures, the investors will receive the original principal plus whatever the payoff is on equity options.
How does an Equity-Linked Note work?
As mentioned above, Equity-Linked Notes are debt instruments in which return is based on the return of underlying equity. Most ELNs are not traded on the secondary market and are kept till maturity. However, the issuer may offer to buy back the notes. In such cases, the buy-back price before maturity may be below the amount invested in the first place.
How Equity-Linked Note can be used?
Equity-Linked Note can be used as a part of the investment portfolio of investors. Different investors use Equity-Linked Note with different objectives.
- As there is a security of principal amount in ELN, investors who are less risk appetite i.e. Investors with lower risk attitude towards equity investment may prefer investment in Equity-Linked Notes.
- An Equity-Linked Note that employs leverage will attract investors seeking higher returns.
- Investors who want to hold/delay the tax may prefer ELN because they are required to pay tax on the redemption and these notes can’t be redeemed before its maturity.
Get complete FRM Online Course by experts Click Here
Key Risks associated with Equity-Linked Notes:
- Market Risk: As Equity-Linked Note is an investment instrument in which the return of investment is linked to the performance of the underlying equity, market risk is associated with it. This is because the performance of underlying equity depends on the performance of the market that is fluctuating in nature. Changes in some factors such as the price of underlying shares, interest rates, time to maturity of ELN, the volatility of the shares, etc. can be sudden and unpredictable. These changes can result in the value of ELNs moving adversely against the investors.
- Credit Risk: Equity-Linked Notes are, usually, an unsecured debt obligation of a particular company. This means ELNs are subject to the trustworthiness of the respective company. If the issuer fails or defaults, investors may lose either a part or whole investment.
- Liquidity Risk: Liquidity refers to the ability of an investment to be easily converted into cash. The secondary market for equity-linked notes is typically illiquid, as notes are designed to be held until maturity. Investors should be prepared to stay invested until maturity, because selling the note before its maturity date may result in loss of capital.
- The potential loss of Capital: If the underlying share price drops to zero, investors may lose their entire capital.
Author: Hetvi Shah
About the Author: Hetvi is a BBA(Finance) graduate. She is currently pursuing an MBA with Finance specialization. She has a keen interest in Financial Market, Financial Management, and Financial Analysis.