Introduction
It was just two decades back that a new and novel form of structured notes that we see today were only available to institutional investors and High Net Worth or HNW retail investors wherein the dealings took place in plush offices in the US and UK.
But today, thanks to the technological prowess and the power of the internet, these hybrid securities are more and more available even to the common man. The notes comprise debt as well as equity.
You can have the notes customized to tailor for your independent financial needs or obligations which is why the notes are becoming more and more popular in the investment world.
When you have a look at it, Equity Linked Notes and Reverse Convertible Notes belong to the Structured product catalog indeed. However, their profiles, structures, and complexity vary.
Let us unveil the key differences covering Equity Linked Notes Vs Reverse Convertible Notes. Helping you get started further:
What are Equity Linked Notes- Meaning and Conceptualization explained
Equity-linked Notes otherwise popularly known as ELNs are notes wherein a larger portion of the notes have underlying equity assets that form a predominant portion of this particular investment product.
The ELNs are issued by product issuing firms by including a wide range of equity-based assets that form a major part of the asset allocation process. These include equity shares, securities, a basket of high-paying stocks, commodities, and futures to name a few.
ELNs do not guarantee investors an exact return on capital. This is because the notes are predominantly exposed to the volatility of stock markets. Therefore, the capital investment and the potential gains or returns on the investment depend on the performance of assets that lie within ELNs.
If the underlying assets perform well during the time of maturity, then investors get generous returns on their investment plus their capital sum.
On the contrary, if the underlying assets of the ELNs do not perform at expected levels during the time of maturity, then investors might have a forgo a significant portion of their returns on investment. And, they might also lose a portion of or the entire value of their capital wallet.
What are Reverse Convertible Notes- Meaning and Conceptualization Explained
Reverse Convertible Notes can be abbreviated as RCNs. These are notes that comprise underlying assets.
The asset allocation comprises equity, shares, high-paying stocks, a basket of securities, and currencies to name a few.
If the linked-in assets perform well in the market, the investor gets his principal money back. This is coupled with interest payments that correspond to the RCNs.
On the contrary, if the linked-in assets do not perform as expected, then the capital value of the investment is converted into a specific number of shares and these shares get credited into the investor’s account.
However, you must understand an important thing here. A specific formula applies wherein the product issuing firm converts the principal investment of the RCN into shares.
Equity Linked Notes Vs Reverse Convertible Notes: Key Differences as Explained
These are the key differences covering Equity Linked Notes Vs Reverse Convertible Notes. Helping you through with a run-down into the same:
Structure and Purpose
ELNs are hybrid securities that combine one or more bonds with equity-based assets. Here, the performance of the linked-in assets is tied to the price movements of a market index. Although investors might receive periodic coupon payments, the principal sum of the ELNs depends on the performance of the assets. If linked-in assets perform well, they might receive more value over their principal amount.
Whereas, with respect to RCNs, things work differently here. The RCNs are tied to specific barrier prices as your knock-in. If the knock-in levels are met, then investors receive their principal amount during maturity of the same.
On the contrary, if the estimated price limits are not reached by linked-in assets of the RCN, then the investment value automatically gets converted into stocks or shares as decided by product issuers and gets credited to the investor’s account.
Evaluating the risk profile between the two
With respect to ELNs, the main risk lies in the downside of the underlying assets. As long as the linked-in assets of ELNs do not fall too low below the threshold limits, the investor’s capital amount or principal money gets a reasonable level of protection. The investors lose their capital wallet only when the underlying assets fall dramatically. Few ELNs also come to you with a partial capital protection aspect.
Whereas, with respect to RCNs, the investment option proves riskier for investors as the entire capital wallet is exposed to the downside risk of the underlying equity. The investors get their principal money back only when specific knock-in levels are reached with respect to the underlying assets of RCNs. Otherwise, the product issuer applies a formula based on which the investors receive a specific number of shares or equity stocks. The value may or may commensurate to the exact value of the investor’s principal amount. The conversion can lead to a potential capital loss in this case.
Determining the return structure
Investors of ELNs usually receive fixed or floating coupons from the respective product issuing firms. The returns on investment are usually higher as compared to traditional bonds or fixed-income securities. The capital sum or the principal amount of the ELNs however depends on the performance of underlying equity the ELNs are backed with. If the performance of underlying assets declines, the capital money the investor might receive during the time of maturity may also be reduced to that extent.
Whereas, with respect to RCNs, coupon payouts are usually higher for investors as they allow their underlying assets to be exposed to the entire downside risk of market volatility. However, if specific levels of linked-in assets are not reached, then the principal money significantly reduces in value as the amount is converted into a specific number of shares or stocks at on-par market rates. The coupons may not be able to offset the capital loss for the investor in this scenario.
Evaluating the level of exposure for the investor
With respect to the ELNs, the investors get exposure to the extent of involving themselves on an upside participation or positive index level if the underlying assets of ELNs perform really well in the market. The capital is generally protected 100 percent or investors usually get a fair protection net at least on a partial sum of their principal investment. However, the investors may not get an exposure to the index of market assets if the underlying assets decline in the market.
Whereas, with respect to RCNs, the investor’s capital money is completely exposed to the downside risk of the underlying equity. The product issuers incubate specific barriers or knock-in limits for investors to be eligible to receive their principal money in cash.
If the linked-in assets fail to reach the expected figures, they get the asset and not the cash. The value of shares or stocks post-conversion may or may not match the investor’s capital investment.
What happens during maturity?
For ELNs, if the value of underlying assets surpasses their initial purchase points, then the investors are eligible to receive their principal payouts and the interest earnings on the specified portfolio. If the underlying assets do not fare well, then they might just receive their capital money alone from the product issuing firm.
Whereas for RCNs, things work far differently here. If the linked-in assets of RCNs reach barrier limits or specific knock-in limits, then the investors receive their principal payout plus coupon earnings and the notes might redeem even before maturity. And, if assets fail to reach specified knock-in limits, even during the onset of maturity, then they receive shares or stocks that might be of a lesser value as compared to the initial cap investment of the investor.
The Bottom Line
ELNs are more suitable for risk-averse investors who might want at least a partial sum of their principal investment while getting reasonable exposure to the equities market.
On the contrary, RCNs are riskier investments that are taken up by investors who have a better degree of risk tolerance as their entire cap is exposed to the downside risk of equity-based volatility. Although the coupons are higher, the investors might have to take a lesser value of the asset in the form of stocks or shares if the underlying assets plummet in the market.
As an investor, you must exercise a degree of caution and read offer documents carefully for ELNs or RCNs.
What are your thoughts on this? Do let us know in the comments below!
Frequently Asked Questions or FAQs
What is meant by underlying stock?
Answer: Underlying stock refers to the assets that get embedded within structured notes. These assets comprise stocks, equities or currencies to name a few.
What is your understanding on original investment?
Answer: Original investment refers to the initial investment or the principal money an investor invests while he signs up for a structured product.
Define initial price
Answer: Initial price refers to the original investment amount with which the linked in assets have been bought or purchased in lieu of your note. The initial price vis-a-vis the strike prices or achieved prices on the notes are predetermined by financial institutions or by product issuing firms who give away these notes to retail or institutional investors.
What is meant by a ‘put’ option?
A put option is a predetermined option that is incubated on a note-based derivative or a future in the market.
What type of passive income do you earn with ELNs or RCNs?
Answer: You can get coupons based on the interest rates the notes have been designed with during their stage of inception. The interest can be monthly or quarterly for investors. This again depends on the terms of your notes. The coupon rate depends on the interest rate again.
Investors who participate in upward equity participation receive other capital intensive emoluments like dividend earnings or too. This happens as the stock closes or during the onset of the maturity period of the notes.
