Principal-Protected Equity Linked Notes

Example 2:  Equity Basket Linked Note with Fixed Payoff

Another variation of the Principal-Protected Equity Linked Note is an Equity Basket Linked Note with Fixed Payoff tied to the movement of several major equity indexes.  This type of note is structured as a certificate of deposit (CD) or zero coupon note paying a very high return at maturity, with payment contingent upon all of the underlying equity indexes staying within upper and lower return thresholds. 

A common Basket Equity Linked Note is tied to the returns of three equity indexes - the S&P 500, Dow Jones Euro Stoxx 50, and Nikkei 225.  The upper and lower boundaries might be set at +27.5% and -27.5%, and the note matures in 30 months.  As long as the closing prices of ALL THREE indexes remain within the specified percentage return range for the life of the note, the Basket Equity Linked Note will pay out 32.5% times the principal and return 100% of the principal itself at maturity.  If ANY ONE of the three indexes crosses the upper or lower return boundary, however, only the investor's principal is returned at maturity. 

Example 1:  No barriers broken = 32.5% payout + principal


Example 2:  One index breaks barrier = 0% payout + principal


For the investor, a Basket Equity Linked CD offers superior returns even if all three equity indexes fall.  This instrument provides an excellent hedge against the likelihood of a sideways range-bound market associated with a slowing global economy.  As long as all three underlying equity indexes remain within the upper and lower strikes, a large percentage return is guaranteed.  Since the investor also receives guaranteed principal protection in the event the lower return barrier is broken, the note has minimal nominal risk.  The true risk, of course, is the opportunity cost of not investing in either a risk free instrument such as U.S. Treasuries or the underlying equity indexes themselves (in the event they rise above the upper return barrier).

For the bank seller, there is a high probability that at least one of the three underlying equity indexes will cross an the upper or lower return barrier.  If one of the equity indexes breaks a +/- 27.5% return barrier within the next 30 months, the bank must return the investor's capital with no gain or loss at maturity.  This is a benefit to the bank since the bank essentially gets free access to the investor's capital with no obligation to pay interest for the life of the note.  The risk to the bank is that none of the three closing equity index prices will breach a return barrier, in which case the bank must pay the investor 32.5% at maturity.  To offset this risk, banks typically hedge with a combination of equity index put and call options.  The bank will attempt to immunize itself and charge a spread to the investor that exceeds the cost of the hedge. 


Principal-at-Risk Equity Linked Notes

The second major group of Equity Linked Notes leaves the investor with his or her principal at risk under certain specified conditions.

Example 1:  Reverse Convertible Equity Linked Note

One of the more popular Equity Linked Note structures is the Reverse Convertible Equity Linked Note.  A typical converible bond is a long term note paying regular coupons, with an attached call option or warrant that allows the bond holder to convert into preferred or common stock of the issuing company if a specified event occurs (usually an increase of the company's stock price above the conversion option strike price). 

A Reverse Convertible Equity Linked Note has a guaranteed coupon and full principal protection as long as the underlying company's stock price does not drop below a certain barrier level - typically 60-80% of the initial stock price (Zones 1 and 2 below). 



In the event that the underlying reference stock price drops below the barrier, the Reverse Convertible Equity Linked Note holder's principal is no longer guaranteed (Zone 3 above).  In essence, if the lower barrier is broken, the note's principal starts floating with the underlying stock price. This is roughly equivalent to forcing the note holder to convert into the company's stock (hence the term "Reverse Convertible"), although the conversion transaction does not actually occur.  Rather, the selling bank is no longer required to pay back the investor's full principal at maturity, and the actual amount of principal returned depends upon how far below the barrier the equity price has fallen. 

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