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Making Sense of Equity Yield Enhancement Products

In the previous post, I asserted that the Dual Currency Investment (DCI) is not effective in meeting the objectives of a yield investor. How about another popular structured product – the Equity-Linked Note (ELN)?

How does a typical ELN work?

It involves the investor selling a put option on the underlying stock and placing the notional investment amount with the bank. What it means is that the bank has the right to sell (i.e. put) the stock to the investor at the pre-determined strike price on maturity date.

Illustrating with an example

Notional investment: SGD 50,000

Underlying stock: SingTel

Spot price: SGD 3.68

Strike price: SGD 3.50

Tenor: 3 months

Coupon: 8%p.a. (= SGD 1,000 for 3 months)

The ELN is usually issued at a discount to par, i.e. in the above case, investor forks out SGD 49,000 as initial outlay.

On maturity date 3 months later, there are 2 possible scenarios:

1) If SingTel’s closing price is at or above SGD 3.50, investor receives SGD 50,000

2) If SingTel closing price is below SGD 3.50, investor received 14,286 shares of SingTel (equivalent to SGD 50,000 at strike price of SGD 3.50 per share)

SingTel-chart

 

Source: Google Finance

Why are ELNs popular?

Discretion over Margins

Bankers like to sell ELNs as they have more discretion over the pricing (and thus their fees!). The embedded options in the ELN are priced using financial models that most investors will not have access to. In addition, as most of these products are quoted “over-the-counter” (OTC), the option pricing is generally not observable – the opacity therefore gives bankers plenty of “room” on pricing.

Price Discovery?

High net worth investors who are well-banked may have to get quotations from several bankers in order to get a better sense of the market pricing for the ELN. But if you are a retail customer or an investor with small ticket size (say less than SGD 250,000), you will just be a price-taker and have little bargaining power against the banks. I have heard of instances where retail customers are shown ELN with no discount on the strike price by their bankers; imagine how “fat” the banker’s fees can be in such cases!!

Buy at a discount?

One other commonly touted selling point is that an ELN enables “you to potentially buy a stock at a discount to current market, while earning some yield”.

But is that too good to be true? If the stock rallied, the investor will have to forgo the upside and earn only the coupon; if the stock plunged, the investor has to buy the stock at the pre-determined strike price and will suffer huge mark-to-market losses.

Citigroup-chart

Source: Google Finance

Imagine one who has invested in a Citigroup ELN during the Global Financial Crisis. During those extremely volatile periods, a two-month ELN on Citigroup with strike price at 70% might yield more than 50%p.a.! I recalled some investors then happily buying into such ELNs, lured by the seemingly attractive yield and steep discount.

What happened next was history. Citigroup went on a free fall and plunged by a whopping 96% in the next 18 months. Unlucky investors whose ELNs got converted into Citi shares during that period may still be sitting on losses now.

So what is your take-away on ELNs for the yield investor?