Fixed Income Trading

Equity Linked Notes (ELN)

What are Equity Linked Notes (ELNs)?

Equity Linked Notes (ELNs) are investment products that combine fixed income investments with additional potential returns linked to the performance of equities. Equity-linked notes are typically structured to return a variable interest portion of the initial investment, depending on the performance of the linked stock. ELNs can be constructed in a number of different ways, but the common version works like a stripped-off bond, combining call options on a specific security, a basket of securities, or an index like the S&P 500 or Dow Jones. In the case of a stock index-linked instrument, the security is often referred to as a stock index-linked instrument.

Understanding Equity Linked Notes

Compared to regular bonds, equity-linked notes offer investors a way to protect their capital while also potentially earning above-average returns. In theory, the upside potential of ELI returns is unlimited, while the downside risk is capped. Even in the worst-case scenario, most equity-linked instruments offer full principal protection. That’s why this structured product appeals to risk-averse investors who remain bullish on the market. That said, equity-linked notes are only paid at maturity, so if only the principal is eventually returned, there is an opportunity cost of locking in that money.

How ELN works

In its simplest form, a $1,000 5-year equity-linked note can be structured to use $800 in the fund to buy a 4.5% yield-to-maturity 5-year bar bond, then reinvest and reinvest another $200 A call option on the S&P 500 over the 5-year term of the note. The option has the potential to expire worthless, in which case the investor can get back the $1,000 originally invested. However, if the option appreciates in the S&P 500, those gains will be added to the $1,000 that will eventually be returned to the investor.

Equity Linked Note Caps, Participation Rates and Leverage

In practice, an equity-linked note will have a participation rate, which is the percentage amount by which note investors participate in the appreciation of the underlying stock. If the participation rate is 100%, a 5% increase in the underlying asset is a 5% increase in the final payment of the note. However, the cost of building and managing an ELN reduces participation rates. For example, with a 75% participation rate, a 5% appreciation of the underlying asset is only worth 3.75% to the investor.

Equity-linked notes can also use different structures and features. Some will use an averaging formula to smooth the returns of the equity-linked portion, or limit the periodic cap of the ELN upside by periodically achieving a certain level of returns. There are also some types of equity-linked notes that use dynamic hedges instead of options, using leverage to increase the return on the underlying stock. Overall, equity-linked notes can be a powerful tool for investors looking to protect their principal while still having the potential advantages of investing in stocks.

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