What is an Equity Linked Note?

Malcolm Tatum

Equity linked notes are debt instruments in which the return on the instrument is based on how well the equity securities backing the notes perform. An equity linked note may be backed by one equity security, several equity securities that are considered part of a group or basket, or even some type of equity index. Bonds are often offered with this type of arrangement, using a specific stock or stocks as underlying security. Depending on the performance of those underlying securities, an equity linked note can provide a significant return over the initial investment.

Man climbing a rope
Man climbing a rope

At the time the equity linked note matures, an investor receives both the initial investment and a percentage of any increases made in the value of the securities associated with the investment. That return is also linked to the percentage or rate of participation that the investor holds. For example, if the underlying security experiences a gain of fifty percent and the investor has a rate of participation that amounts to fifty percent, he or she will receive both the amount of the initial investment, plus an additional twenty-five percent of that figure as the profit or return generated by note.

In many instances, an equity linked note is structured so that investors are guaranteed to receive a return that is at least equal to that initial investment. This is true even if the underlying security fails to perform as anticipated, and decreases in value rather than increasing. For the investor, this means that the degree of risk assumed by investing in the note is minimized, although not completely eliminated, since there is still the chance that the issuer could default on the note.

While an equity linked note is typically considered an investment that is held until maturity, there are situations in which the issuer may exercise an option to buy back the note at specific points in time prior to that maturity. In situations where the provisions associated with the investment allow this type of activity, investors would do well to consider the possibility of an early repurchase. This is because in contrast to the guarantee of a minimum return at the point of maturity, the early repurchase is not likely to carry any guarantee that the investor will at least recoup the original investment.

Assessing the potential of an equity linked note means evaluating the nature of the underlying security or securities involved. Should the investor feel there is a reasonable chance that those securities will increase in value by the note’s maturity date, and that the rate of return is equitable, investing in the equity linked note is likely a good idea. If there is some question about the potential for those securities to post any gains between the date of purchase and the date of maturity, the investor may find that pursuing a different investment option would be a wiser course of action.

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