Summary:
- Equity-Linked Notes (ELNs) are structured products that combine fixed returns with the risk of being forced to buy shares if prices fall below a set strike price.
- Investors in ELNs are effectively selling a put option to the bank, which means their gains are capped while potential losses can be significant.
- ELNs may suit short-term, high-risk investors but are generally unsuitable for retirees or conservative investors due to their asymmetric risk-to-reward profile.
A few weeks ago in one of my WhatsApp chat groups, a friend posted that she was thinking of buying Equity-Linked Notes (ELNs) that a local bank offered. It was written with a Japanese stock as the underlying asset.
This sparked a discussion among the others in the group, which among its members includes a fund manager, a bonds expert who spent 20 years with various banks, and a business school lecturer at a polytechnic. The conclusion? It was probably a good idea to stay away because of the risks involved.
This doesn’t necessarily mean the same advice applies to you though.
It could be that the yield offered by a particular ELN might appeal to you; with yields on T-bills and returns on fixed deposits being as low as they are, some people might well do better with an ELN – provided they understand how these instruments work, and the risks involved.
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What are put options?
The first step in understanding how ELNs work is to understand how put options work.
A put option gives the holder the right, but not the obligation, to sell a particular asset at a pre-determined price called the strike price, to the seller within a specified period.
For example, let’s say a stock is trading at around $52, but you think the price will fall because of impending bad news, so you buy a put option with a strike price of $50 for $5. This gives you the right, but not the obligation, to sell the shares to the option seller at $50.
If the stock drops to $40, you can, in theory, exercise your option by buying in the market at $40 and selling (or “putting”) to the seller of the option at $50. Your profit, net of the $5 you paid to buy the option, would then be $5.
Note that the lower the price of the stock, the greater your profit because you have effectively locked in a $50 selling price.
However, if the stock stays above $50 for the whole period, the option expires worthless, and your loss is capped at the $5 you paid, which isn’t too painful.
In other words, as the buyer of the option, you hope the price falls below the strike price because you can then sell the shares at the strike price.
Note however, that the put option seller faces a much higher theoretical loss. If the shares in the earlier example plunge to, say $1, the option seller would be forced to buy shares at $50 that are worth only $1, while his gain is limited to the premium collected, which in this case is only $5.
In theory therefore, the seller of the put option could end up losing heavily.
Now ask yourself: would you rather be the buyer or seller of a put option?
Bearing this in mind, let’s move on to ELNs.
Features of Equity-Linked Notes
According to DBS’ website:
"ELNs have a strike price, which is at a discount to the "spot" market price, and is expressed as a percentage of the spot.
For example, a 95% strike means that the ELN issuer will deliver the stock to the investor when the price falls below 95% of the initial market price on maturity of the note. In other words, on maturity, the investor is delivered the stock at 95% of the initial price.
If the stock price closes at or above the "strike" level at maturity of the note, the investor gets his principal in full. The difference between the principal amount paid to the investor and the initial amount paid by the investor (that is, principal minus the discount) represents the yield on the investment."
Based on this, it should be obvious that because ELNs have a strike price, and delivery of shares takes place if the price falls below the strike price, that ELNs incorporate a put option.
The interesting question to ponder is: who is the put seller, and who is the buyer?
Put option buyer or seller
If you’ve followed the explanation thus far, it should have dawned on you that for ELNs, the investor is actually assuming the role of the seller of the put option to the bank because if the shares fall below the strike price, the bank will exercise the option and deliver the shares to the investor at the strike price.
Stated differently and bearing in mind the preceding discussion, while the potential loss to the bank as the buyer is limited, the potential loss to the investor as the seller of the put, is much greater.
Also, remember the potential gain to the put seller, which is the investor, is capped at the premium received, which in this case is the discount or the stated yield.
Here is the example from OCBC’s website using SingPost shares:
Spot price: $1.45;
Strike price: 97% of spot = $1.4065;
Principal amount: $200,000;
Client pays: $198,080.
The example is based on a holding period of around 32 days and two scenarios are presented:
Scenario One:
SingPost’s shares are above $1.4065 after 32 days, in which case the investor receives $200,000. The profit or yield is $200,000-$198,080 or $1,920.
To calculate the annualised yield:
The yield for 32 days is $1920/$198,080 = 0.969%.
The simple yield per annum is (0.969 x 365)/32 = 11.05%.
If the numbers are plugged into a financial calculator, the compound annualised yield works out to 11.74%.
(The website gives the figure as 11.16%).
Scenario Two:
SingPost’s shares have fallen to $1.39 on the maturity date, which is below the $1.4065 strike price.
In this case, the example says the investor will receive ($200,000/$1.4065) = 142,196 shares.
Since he actually paid $198,080, his effective unit price is $198,080/142,196 = $1.393.
Note that with the market price at $1.39, the investor has more or less broken even, which is probably why the example uses $1.39 as the market price at maturity.
But if the price was, say $1.30 at maturity, his paper loss would be ($1.393 – $1.30) x 142,196 = $13,224. Note also the lower the market price at maturity, the greater the paper loss.
Is having to buy at the strike price a good thing?
The fact that the investor might end up having to buy shares at a price that a month or so earlier was fixed below the prevailing market price is claimed to be a desirable feature of ELNs.
For example, OCBC’s website says a key benefit of ELNs is that you can: “lock in your target price of a share in advance with the ability to decide your strike price.”
Meanwhile, DBS states: “investors may be able to purchase shares at their target levels, below the current market prices, while earning an enhanced yield during the tenor of the ELN.”
Since you are in effect issuing a put option to the bank in exchange for a limited yield, since your downside loss is potentially your entire capital (if the shares fall to zero) and since “earning an enhanced yield” is not guaranteed, make sure you understand this before investing.
It’s important to understand that “enhanced yield” simply refers to a return better than ordinary bank deposits, which is what ELNs offer – but don’t promise.
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So why buy Equity-Linked Notes?
From the preceding discussion, the real benefit of ELNs only materialise if the stock rises or closes above the strike price when the instrument matures, in which case an “enhanced yield” could be earned.
However remember that the yield is capped, whilst the downside risk is large.
ELNs are therefore really only suitable for investors with a relatively high risk tolerance and a very short-term investment horizon. Yes, a decent return can be earned – but in exchange for assuming large downside risk.
Are these instruments suitable for retirees or senior citizens? That’s a question only each individual can answer.
In my view, it is generally not suitable because of the asymmetrical risk-to-reward ratio. Retail investors — let alone seniors — in my view should not be writing put options that effectively insure banks from downside risk.
A final word – choice of underlying asset matters
Of course, much depends on the choice of the underlying stock. A high-volatility stock would mean a higher yield can be earned – but by the same token, it also means greater risk of the price ending up below the strike.
If the underlying is strong and has sound fundamentals, then the yield on offer will not be that attractive, but since the chance of the price ending up above the strike is greater, then this might be appealing to some investors.
Ultimately, it would depend on your risk tolerance, the short-term outlook for the stock chosen, and whether you can afford to lose part or all of the capital invested.
