By Mildred Moss, Contributor 
Moss
MOST INVESTORS are familiar with the traditional mechanism for financial wealth accumulation and preservation stocks and bonds. However, in recent times there has been a proliferation of financial instruments designed or engineered as alternatives to the conventional methods of debt or equity financing.
These structured products are created to meet specific financial and investment objectives whereby clients have the ability to customise parameters such as maturity, level of principal guarantee, coupon stream and the underlying asset(s). The gamut of structured products includes warrants, index and other asset linked notes, convertible securities, equity linked notes, exotic options and swaps, to name a few. Each transaction is unique, however, they all share a common characteristic in that their values are linked to or based on one or more underlying assets such as stock prices, interest rates, currency exchange rates, commodity prices or indices.
There are numerous categories and permutations of structured products available to investors, and addressing them all would be daunting. One of the more popular instruments, and the focus of this article, is Equity Linked Notes: An Equity Linked Note (ELN) is a hybrid security that combines elements of two asset classes stocks and bonds. Among its features, most ELNs provide a principal guarantee with an embedded call option that enables the investor to participate in the appreciation of the underlying asset(s) that may include blue chip and technology stocks. ELNs may be structured for a term of between 30 days and 12 months and coupons can be at a fixed rate or variable rate.
A GOOD ALTERNATIVE
ELNs can be a lower risk alternative to a direct share investment in times of market uncertainty where investors want to continue participating in a bull market but fear a correction that could wipe out their investments. Additionally, an Equity Linked Note enables the investor to place some of his or her capital gains into a security that offers continued participation in the stock market over the life of the note, with 100 per cent downside protection. In other words, if the market reverses its upward trend, the investor's principal investment is protected by the creditworthiness of the issuer just as for all bonds. Specific users of ELNs include retail investors with the appropriate investment knowledge and experience; sophisticated high net worth investors, fund managers, insurance companies, government and government agencies, corporations, financial intermediaries and investment and commercial banks.
HOW DOES THE ELN WORK?
Recently, I came across an ELN offered by U.S. broker dealer, Lehman Brothers Inc. The offer: a one-year convertible bond. The Note is a debt instrument that pays a quarterly coupon of 11.25 per cent per annum, with interest calculated on a 360-day basis. However, the principal payment at maturity is tied to the value of the underlying securities; in this case, a basket of US stocks comprising Citigroup, Wal Mart Stores and Cisco Systems.
To illustrate, with an investment of US$50,000.00, the note provides 25 per cent downside principal protection. In other words, if none of the underlying securities trades below the trigger price or 75 per cent of the initial offer price investors will receive US$55,625.00, being $50,000.00 at maturity in addition to the quarterly coupon stream. However, if one of the underlying securities, such as Cisco Systems, for example, trades below the trigger price of $14.83, or 75 per cent of the initial offer price of $19.77, the investor will receive 2529 Cisco shares calculated as $50,000 divided by $19.77 at maturity plus the quarterly coupon stream.
THE RISK FACTOR
The above note does not allow the investor to participate in the equity linked upside returns, but does provide partial principal protection and may appeal to a moderately aggressive investor. A conservative investor may consider what is called a Principal Protected Note, where in lieu of coupon payments, pay-off at maturity equals the return of the principal investment plus any appreciation that may result from price changes on stocks that would normally be considered too risky by the investor.
Risks associated with ELNs are similar to the risks present in most financial instruments, including credit risk, liquidity and market risk. However, due to the generally customised nature of these instruments, managing these risks presents unique challenges. For example, ELNs typically trade over the counter, where the dealer controls the ask price as opposed to traditional securities that are relatively fair and objective and where the market price in the main depends on market supply and demand.
DEMAND FOR
CUSTOM SOLUTIONS
There is growing demand for more customised solutions to financing and investment considerations. Structured products like ELNs are able to meet particular needs and provide added value through above average returns and portfolio protection, lower funding costs to corporate or governmental issues, reduced transaction costs, capital gains taxes, or management fees associated with buying and selling securities. Over time, as the performances and trading characteristics of structured products like ELNs are better understood by investors, it appears likely that the Equity Linked Noted will increasingly move into the mainstream of today's investment options.
Mildred Moss is chief operating officer of Sterling Asset Management Ltd.
