Reflection: Equity Linked Notes from Local Banks – Risk and Rewards

Contributed by warriortan, #investforyourself

Thought of sharing what I have learned about Equity Linked Note lately and my reflections on this financial tools (note I don’t use the word investment), so that in case you come across it, you won’t be as blur as I was.

We are still going strong … 

Anyway, we had our 3rd monthly lunch last Thursday. It is great that the group made a point to come together once a month during lunch to chit-chat actively about nothing except financial planning and investments, each contributing their own experiences and sharing the investments that they have made.  The key topic for last Thursday gathering was Equity Linked Note (ELN) issued by our local banks.

My old memory on ELN started to return as we chatted …  I recalled that I was offered this “special investment opportunity” previously but I didn’t take it up. I vaguely remembered it was because I felt the whole setup was overly complicated and my simple mind just felt that since I didn’t understand it fully, better to stay out of it. Kinda think of it, it has been almost one year since I was last offered one. I wondered what happened in between. Has the market for ELN cooled down already? Or maybe the bank (seller) simply gave up on me after receiving my rejection after a few times. (any update that you can give me?)

header_Equity-Linked_Notes-

What’s an Equity Linked Note

Anyway, the lunch topic tickled my curiosity to learn more about ELN, giving myself a second chance to understand it.

For some of you who are also unfamiliar with ELN, the following formal definition may just “help” you:

“An Equity Linked Note is a hybrid fixed income instrument whose return is partially dependent upon the performance of an underlying equity (stock, basket of stocks, index, basket of indexes, or some mix of these). These instruments are generally designed for the Over the Counter (OTC) institutional investment market. However, there are a growing number of exchange traded Equity Linked Notes available to retail investors.” From Financial-Edu

Or if you are a “wiki-fan”,

“Equity-linked note (ELN) is a debt instrument, usually a bond, that differs from a standard fixed-income security in that the final payout is based on the return of the underlying equity, which can be a single stock, basket of stocks, or an equity index. Equity-linked notes are a type of structured products. (from wikipedia

Generally, there are two main categories of Equity Linked Notes:

  1. Principal-Protected ELN that offers guaranteed protection of the investor’s principal. These are often linked to a broad equity index such as the Nikkei 225, S&P 500 etc. Maturities range from 1 to 3 years. They are issued by large banks with the necessary assets to guarantee the investor’s principal in the event of a significant equity market drop.
  2. Principal-at-Risk ELN leaves the investor with his or her principal at risk under certain specified conditions.

The Key features of a ELN

Embedded Optionality – Issuing banks price these instruments based upon a combination of implied and historical probabilities that the underlying equity return will or will not move through one or more of the barriers before the expiration date of the note.

Unique or Custom “Rewards” – there is no limit to variations on an equity linked note’s potential payment structure, when the payments occur, the conditions that trigger them, or their magnitude.


So, what’s available locally

In our local context, and based on my own personal experience, I have only seen one generic type of ELN being offered so far. From the group conversation, it also seemed to me that the rest were offered the similar type of ELN. Maybe that is the most popular one (if not the only type) here that is offered to retail investors or is it the most lucrative 😂

Let me use an example to illustrate what it is like and how it works.

In May 2016, this is the ELN that I received:

ELN on SembCorp, with a strike price of S$ 2.698. Strike is 95% of the Spot Level 2.84.

Add-on size – incremental blocks of 20,000 shares or roughly SGD 54,000
notional.

Bull Underlying Stock – SembCorp Industries
ELN Issue Price – 97.62%
Reference Spot – 2.84 limit
Strike Price – 2.698 (95% of Reference Spot)
Payment Date – 13th June 2016 (14 days from trade date)
Fixing Date – 12th July 2016
Delivery Date – 15th July 2016
Yield, Annualised – 27.81%
Issuer – XXX

It seems Complicated right? Let me share my analysis

So, my nice bank was kind enough to offer me a excel spreadsheet to help me understand it better:

ELN

Let me try to explain

The note interest rate is 27.81% per annum, the holding period is 1 month and the underlying equity is Sembcorp Industries (SCI).

First, there can only be 2 outcomes on 12th July when this ELN expires.

Outcome A : Closing price of SCI on July 12th > strike price ($2.698), client receives all his/her principal, I.e. $53,960 and a “reward” of $1284 (one month of 27.81% per annum interest rate)

Outcome B : Closing price of SCI on July 12th < strike price ($2.698), client receives 20,000 shares of SCI. But because of the upfront discount, the break-even price of SCI to the investor is $2.63379.

It all seems like a pretty good deal. The SCI price at launch date was $ 2.84 per shares. You just have to “tahan” one month and pray very hard that the price doesn’t go below 95% of $2.84 and then you will get a handsome reward 2.44% for one month of holding period.

Is it really so good?

Maybe, but in my view, this is no different from speculating or “gambling”. You are really praying for the price not to drop.

If you analyse it rationally, your upside is limited ($1284, no doubt a handsome profit) even if the share price goes up significantly but the downside is unlimited and that’s scary. If the price collapses below $2.698 to even $0.01, you will be forced to buy it at $2.698. You can’t sell out in between to cut your losses.

So if you reverse the role with the bank, the bank’s downside is limited ($1284) and because the bank is going to hold your money for a month and it knows that you die die have to buy at $2.698. There are multiple avenues for them to make money based on all these certainties. So the bank will always win … sounds like the banker in a gambling scenario, right?

So, will I be interested in it?

I probably will not participate for the following reasons:

st_20160508_dcsc08_2274319

(a) This feels like gambling unless you are so confident that the share price of the underlying company will not drop. But who’s knows? If I know, I will be a billionaire many times over. 😎

(b) The capital outlay is quite substantial, in this case, at least $50k

(c) I could be stuck with holding a particular company shares that I don’t really fancy

(d) What if the share price drops significantly? I have absolutely no way to cut loss.

(e) What if the share price increases significantly, I don’t get to benefit other than the “promised” reward.

(f) While the 27.81% yield sounds very tempting, it is only for a month. So your profit is limited to that one month yield. But the downside will stay with me for a long long time if something fundamental about that company has changed. So, in my opinion, I don’t think the risk is worth the reward.

(g) If I am interested in the underlying company, I will be better off to buy its shares rather than being forced.

(h) If the capital outlay is small or if I am a rich person with money to “spare” for some fun, maybe I would give it a go and see if I can win … again it sounds like gambling, doesn’t it?


In a nutshell,

Well, for me, I think plain vanilla, slow and steady investments fit me better.

There are no lack of bad experiences shared about ELN on the web (but to be fair, what is the likelihood that one will blog about good experiences? So you should evaluate it for yourself):

By Straits Time: Retail investors, steer clear of complex structured notes

How the bank take advantage of you through Equity Linked Note (ELN)

Investing in an equity linked note

If you are still interested, you can look up the following banks to talk to them:

DBS Equity Linked Note

UOB Equity Linked Note

OCBC Equity Linked Note

equity-linked-note-detail
An example of a ELN available on the DBS website

Hope you find something useful in this post for you.

If you disagree with the view above or have additional inputs to add, please feel welcome to drop me a note in the comment box below.

Have a great long weekend folks.

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4 thoughts on “Reflection: Equity Linked Notes from Local Banks – Risk and Rewards

  1. Hi warriortan,

    What if the share price drops below the strike price in between? Does that mean I have to take the shares at strike price already?

    Like

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