Hungry for returns? Look at Equity-Linked Notes

An Equity-Linked Note (ELN) is a yield-enhancing alternative investment product traded over-the-counter. It is typically issued by banks and financial institutions in many financial markets worldwide. ELNs are investment products that aim to increase yields on cash reserves while taking a short-term directional view on their underlying shares. They are structured as zero coupon bonds and are an alternative to direct share investing.

By investing in an equity linked product, an investor agrees to purchase or sell listed stocks at a future date for an agreed price. The number of shares or the financial gain and loss customers will receive at maturity depends on the price performance of the stocks selected.

Structurally, ELN is a combination of a debt instrument and an option on an underlying that enables an investor to make a directional bet on the upside (Bull note), the downside (Bear note) or within a trading range (Strangle note) of the underlying.

The underlying may be a single stock, a basket of stocks or an equity index. It is the performance of the underlying that usually determines the return on an ELN.

Which product should you choose?

Markets broadly offer 3 types of ELNs. They are all structured as zero coupon bonds and can be tailored to a client's requirements through the ability to set the strike price.

The three types are;

* Bull Instruments - most suitable if your stock view is mildly to strongly positive

* Bear Instruments - most suitable if your stock view is mildly to strongly negative

* Strangle Instruments - most suitable if your stock view is flat or operating within a small range

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When investing in ELN, an investor more or less needs to peg it to a stock that he/she would like to own. It is prudent to go with established companies or a basket of blue chips. Even if these stocks drop below the strike price and the depositor has to buy them, they can be reasonably sure they will eventually bounce back and so one win's either way.

That said, notes linked to more speculative stocks can be attractive because they carry higher interest rates. Timing is important. Linking a note to a stock that has suddenly soared could be risky.

Another caveat: it is difficult to cash in an equity-linked note before it matures. Banks allow depositors to get back their time deposits early in exchange for a fixed penalty, but you have to negotiate to do that with an equity-linked note. You can only sell it back at a price dictated by the issuer and hence your exit chances could be slim. This is because the issuer, which may be a bank or a stock brokerage, deals with options, warrants and other derivatives, often with more than one counter-party. It cannot unwind its positions easily before the contracts mature.

As any sensible investor one is bound to ask - how safe is your money, then? It's as safe as bank accounts can be in India, where excellent regulatory systems have kept the banking system sound even during the Asian financial crisis "" even though there is precious little covered with deposit insurance scheme.

Needless to say, one needs to deal only with reputable financial institutions with a track record. A thorough check on the stock to which the note is linked is a reasonable expectation from the investor before picking up the note. One also needs to ensure that the price has not soared because of one-off deals that may not pan out. And in any case one cannot be the passive bank depositor when you buy an equity note.

You must be psychologically prepared to see share prices fluctuate - that's the price you pay when you play big!

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(Shiv Kumar (Sr. Consultant) and Kishore Kumar Ramakrishnan (Consultant) are working with the Financial Securities Group at Infosys Technologies)