Equity-linked notes (ELNs) are a type of structured financial product that offers investors a way to participate in the performance of an underlying stock or equity index while retaining the principal protection of a bond. These notes are a hybrid security, combining the characteristics of a debt instrument with the potential for equity-like returns.
They are part of a bigger family of instruments that offer investors a chance to receive higher income if they prove to be right in their prediction about the future market price of the instrument’s reference asset. Those are called ‘structured notes’ and are a popular investment offering of private banks around the world. Their marketing is mostly focused on the wealthy audience – but not those sophisticated enough to ‘deconstruct’ the structured note, i.e. purchase a fixed-income element and an over-the-counter option on the asset of interest themselves.
How ELNs Work
An ELN’s value is tied to the performance of a specific underlying asset, which could be a single stock, a basket of stocks, or an equity index. The note has a maturity date, and at this time, the investor receives a payout based on the performance of the underlying asset. The payout structure can vary significantly but generally falls into two main categories: principal-protected and non-principal-protected.
- Principal-protected ELNs guarantee the return of the investor’s initial principal at maturity, regardless of the underlying asset’s performance. The potential for equity returns comes in the form of an upside participation component. For example, the investor might receive their principal plus a percentage of the underlying stock’s gains, often with a cap on the maximum return. If the stock falls, the investor still gets their principal back, but with no equity return.
- Non-principal-protected ELNs (also known as “unprotected” or “at-risk” notes) do not guarantee the return of the full principal. The investor’s return is fully dependent on the underlying asset’s performance. If the asset declines, the investor may lose some or all of their principal. These notes often offer higher potential returns to compensate for the added risk. A common example is a “bull note” where the investor receives a multiple of the underlying stock’s gains but suffers a loss if the stock falls below a certain threshold.
Utility of ELNs
ELNs are useful for investors seeking to diversify their portfolios and tailor their risk-return profile. They can be a way to gain exposure to specific stocks or markets without directly buying the shares. For investors who are bullish on a particular stock but want some level of downside protection, principal-protected ELNs can be an attractive option. They offer a way to participate in potential gains while mitigating the risk of significant loss. Conversely, non-principal-protected notes can be used by sophisticated investors who have a strong conviction about an asset and are willing to take on more risk for the potential of higher returns. ELNs can also be tailored to specific market views, such as a neutral or bearish outlook, by incorporating various option strategies.
The ELN Naming Convention
It’s important to note that the term “equity-linked note” can also be used for a different type of security, particularly in private placements or for institutional investors. In this context, an ELN may be structured as a debt instrument purely for regulatory or legal purposes, even if its payout is fully and directly tied to the performance of an underlying equity or equity portfolio. For instance, a company might want to offer investors full exposure to a specific stock’s value but issue the instrument as a note to satisfy certain regulatory requirements, such as those related to debt issuance rather than equity. In such a scenario, the note’s redemption amount would be exactly the realizable value of the underlying equity.
This naming convention is generally confined to offerings for professional or sophisticated investors where a high degree of transparency and understanding of the instrument’s structure is assumed. The key difference lies in the payout mechanism: the former has a bond component with equity upside, while the latter is effectively an equity position packaged as a debt security.
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