What Is an Equity Linked Note?

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Investors choose equity-linked notes in hope of experiencing high return rates while avoiding the risks of equity instruments.
Investors choose equity-linked notes in hope of experiencing high return rates while avoiding the risks of equity instruments. (Image: Thinkstock/Comstock/Getty Images)

Equity-linked notes are fixed income instruments that combine the benefits of two supremely distinct financial instruments – zero coupon bonds and call options. Zero coupon bonds guarantee complete principal protection, and call options on an equity instrument provide the opportunity to benefit from positive stock market. The value of the ELN is based on the value of the underlying equity. If the market on which the equity floats appreciates, the value of the ELN would increase. If the value of the market declines, the investor can at least recover the principal amount.

Purpose

Investors use equity-linked notes as part of their investment portfolio. Conservative equity investors who have a low risk attitude toward equity investments may prefer equity-linked notes because of the principal security. Also, investors aiming to defer taxes may prefer these notes since they would only pay taxes on redemption and the notes cannot be redeemed before the end of the maturity period. Finally, investors whose investment structure cannot accommodate high risk or high volume equity investments may prefer equity-linked notes because of the equity exposure with principal security provided by these instruments.

Advantages

Equity-linked notes provide investors with opportunities to earn higher incomes than the normal market deposit. They also allow investors to buy the underlying shares when the call option becomes attractive. In addition, the investor does not have to pay charges such as brokerage commission or taxes on the purchase of shares. The investor can benefit from positive stock market behavior while maintaining his position if the market goes the other way.

Disavantages

Although on paper, equity-linked notes provide principal security, a shift in the price of the underlying equity can lead to declines in the value of the overall instrument. In this case, you might end up receiving an amount lower than your initial investment. You can redeem equity-linked notes are at the time of maturity. However, if you must sell the instrument before it matures, you must sell to the financing firm at a pre-agreed price, which is less than the amount of your initial investment in most cases. You must, therefore, be careful in choosing the underlying equity instrument, as increase in price fluctuations heavily affects the price of the equity-linked note.

Alternatives

Investors looking for better equity exposure can invest in funds with an enhanced equity portfolio backed by investments in federal stocks. Low-risk funds have investments in low risk equity stocks while investing a percentage in government securities for risk reduction purposes. The reason behind the investment in government securities is that they are among the safest investments with a low risk-reward combination. Even if the stocks fail, the government bonds are able to balance the negative impact and still provide a return.

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