Introduction
In today’s investment landscape, we are experiencing a paradigm shift indeed and this was not the case two decades back. New investments are foraying into the market like the Equity Linked Notes Investments. While traditional investors stick to mortgage bonds and equities, there is still a degree of scope for them to explore more. Thanks to financial innovation and a sudden spurt in the rise of investors who are Gen-Z millennials.
When we say, that we can offer you notes that mix equity with that of a structured bond? No, isn’t it? These are structured notes that have fixed security bonds that are linked to one or more derivatives.
You find structured notes that can be customized according to your level of risk tolerance. Such a variant of notes is named ‘Equity-linked Notes or ELNS. Well, let us have you covered on the complete know-how of how the ELNs work.
ELN refers to an underlying equity that is embedded with a debt instrument and does not offer a standardized rate of returns just as a traditional bond does.
This is a type of structured note that is linked to the performance of an underlying stock or share. ELN covers a single stock, a basket of securities, and even encompasses a broader market index as is curated for you by the issuer. Here, the put option or stock prices these ELNs are linked to may affect the performance of the asset.
Unlike regular interest payments as offered to investors via traditional fixed-income securities, ELNs do not offer investors a fixed rate of returns. However, as ELNs are linked to equities, shares stocks, or other forms of underlying assets, investors are offered variable returns from the same. The performance of the underlying equity determines the payoff investors receive at the end of the term period.
Features of Equity-linked Notes Investments
Let us now have a look at the different features of ELNs. Helping you through, with a run down into the same:
1. Has a two-component structure
The Equity Linked Notes or ELNs are characterized by a two-component structure. You have a debt instrument that is linked to an underlying stock or equity. Therefore, investors receive coupon payouts for the debt and return on investment from the performing equity after complying with the valuation process. Equity-linked notes are usually traded in the secondary markets, the way equities do at the stock exchanges.
2. Offers traditional investors with a capital-protection net
Most of the ELNs allow their investors to enjoy principal protection from their initial market price. Say, for instance, you have zero coupon bonds that mature with a pre-determined payout. The maturity date is printed on the ELN.
Here, you receive the capital sum and payouts in the form of coupons that can be encashed into liquid funds. This kind of principal protection ensures that investors get their initial investment amount even if the underlying assets are performing poorly.
And that explains the capital protection safety net, traditional investors are provided with, via ELNs.
However, for ELNs, the principal and interest differ on a case-to-case basis. If the price of the underlying asset hikes up, the investors earn more.
3. Dynamic in nature
Unlike traditional bonds, ELNs are not fixed-income investment options. Therefore, these are financial instruments that deviate from the fixed-interest model. Instead, the interest rates of ELNs are linked to the equity markets making their returns on investment a dynamic one.
4. ELNs are short-term investments
ELNs are short-term securities wherein their maturity period lies anywhere between 1 and 4 months. The investor may receive the final payout comprising of the principal component and the interest payoff calculated from the performance of the underlying assets the ELNs are linked to.
Therefore, most investors prefer holding them until the period of maturity instead of actively trading them in the secondary markets.
5. Caters to diverse investor preferences
ELNs cater to the needs of different types of investors seamlessly. These are financial products that provide capital protection rackets to risk-conscious investors guaranteeing them with the initial cap investment they had done during the initial offering stage.
At the same time, these are investments that also leverage investors who aim for higher returns of investment, thereby adding a layer of complexity to their investment strategy.
Equity Linked Notes Investments- Types Explained
These are the three main types of ELN notes as investments. Let us take a look at each one of them:
1. Principal protection ELNs
As the name suggests, principal-protected notes guarantee the return of capital or amount invested to investors, irrespective of how the underlying stock or equity index performs in the market. Therefore, the safety net these ELNs come with is what attracts traditional or conservative investors to choose them.
As these are structured notes that have debts linked to equity, investors get the potential to earn income returns from the equity and coupon payment options too. In a nutshell, these are lower risk notes aimed at principal money guaranteed to receive from the investor’s perspective.
2. Non-Principal Protected ELNs
In contrast to principal protection ELNs, the non-principal protection ELNs do not guarantee investors a return on their initial capital. Here, the investor’s initial offering is exposed to the risk or the volatility of the equity or stock market.
The returns are calculated on the performance of the underlying assets the notes are linked to.
The final payouts for investors are calculated based on the performance of the underlying stocks or shares. Some investors still take non-principal protection ELNs as they receive higher rates of return especially when they know how to tread waters through volatile markets.
3. Hybrid ELNs
Hybrid ELNs combine the features of Principal and Non-principal protection ELNs. Their structure characterizes partial protection of investment capital and various other innovative elements. Investors can get a portion of their capital back and leverage higher returns of investments through the performance of the ELN’s underlying assets.
The crucial objective here is to allow investors to get exposure to risk-return profiles helping them balance between risk and returns while also allowing them to improve their risk tolerance and catering to specific income objectives.
Benefits of ELNs
Let us now understand the top benefits the ELNs have. Helping you through the same:
1. Higher returns on investment
ELNs provide investors with higher rates of returns as against traditional bonds guaranteed investment certificates or fixed deposits. This is because these are notes that are linked to equities.
2. Principal protection
Most of the ELNs come to you with full or partial protection against the investor’s principal amount. Therefore, investors get a return on their initial investment while they also get exposure to the volatile equity market as the ELNs are linked to assets like stocks or equities.
3. Customized investment choices
ELNs offer investors customized options to create their wealth baskets. You can choose the underlying asset you want for the ELN. It can be stocks or a specific number of shares you may want to choose.
You can also determine the number of shares that get linked to your ELNs. Therefore, you have complete flexibility to choose your structured product that suits your level of risk tolerance or income-earning objectives.
What are the downsides or Risks that are connected with ELNs?
Well, let us cover the factors of risk associated with ELNs:
1. Market Risk
The return on equity-linked notes is directly tied to the performance of underlying shares or stocks. Therefore, investors are exposed to market risks. As you find fluctuations through bearish or bullish trends, the value of these debt instruments can significantly vary.
Although ELNs are designed in such a way that they mitigate market risks, investors have a risk of losing their partial capital investment if the underlying assets of the ELN perform badly in the market.
2. Credit Risk
ELNs are unsecured debt instruments. Therefore, ELNs are subject to risks connected with the creditworthiness of issuing companies or agencies. Therefore, if the issuing company fails or defaults, investors stand at risk of losing a partial or entire sum of their investment
3. Liquidity Risk
ELN investors deal with debt securities that are linked to assets like stocks, shares, futures, or options. Therefore, the markets are impacted by fluctuations of the instruments owing to bearish or bullish trends. Therefore, ELNs are not strong in the liquidity factor.
In other words, investors cannot sell them before their term of maturity. Bid offers in secondary markets may be heavily discounted. Therefore, investors must stay put until the term of the investment.
4. Heavy fees or tax implications apply to ELNs
Like any other form of investment, ELNs also come to you with overhead fees and other in-built costs attached to them. Commissions are paid out to the issuing companies. At the same time, investors must also put up with a portion of their equity earnings as commission payouts to the securities company.
Additionally, investors are also subject to tax implications from potential gains or losses they make via ELNs.
Therefore, one must calculate taxes and other overheads before venturing into ELNs as their choice of investments.
Key Takeaways
Equity-linked notes provide a way for investors to invest without losing their capital amount. These notes are also highly flexible and customizable, as they allow you to link stocks, shares, or securities to the notes.
The returns on investment for ELNs are higher if the underlying assets of the portfolio do well in the market.
Above all, you must always choose an investment plan after considering the financial gains you would want to make for yourself in the longer run vis-avis your risk tolerance aptitude. The type of structured product you want must be decided after you evaluate your risk profile.
Investment products rely on market volatility or change in market conditions and the scenarios keep changing.
Principal-protected ELNs may be appealing to risk-averse investors who expect a return on the initial investment. The underlying stock or index vis-a-vis underlying equity gains helps you understand markets better!
By reading through market documents carefully, you can make well-informed decisions concerning ELNs. Tax-saving guidelines also cover market risk documents which you must keep track of.
