Equity Linked Debentures

Knowledge Series

Jan 2011

What is ELD
ELDs are floating rate debt instrument whose coupon is based on the returns of the underlying asset such as S&P CNX Nifty. The issuer of bond invests a pre-determined part of the principal amount collected in fixed income securities like bonds, which provide principal protection while the balance is invested in call options which provide the exposure to returns of equity index. Thus, it is structured in a way to give 100% capital protection with a provision for equity participation. ELDs are floated by many issuing banks like Citibank, Deutsche bank, Merrill Lynch, Kotak bank and others. To minimize the credit risk, usually ELDs are rated by credit rating agency ELD offers: 1. Capital Protection 2. Participation into stock market returns

ELD Return Payout

As seen from the graph below, ELD protects downside & at the same time limited/predefined participation into Nifty returns when it goes up. Therefore, ELDs on an average yields superior returns than FMPs over the long term

Typical Payoff Scenario

Downside capped of ELD

Product Return Equation Principal Protection

+
Guaranteed Coupon (if any)

+
Fixed participation Rate into Nifty returns over the tenure of ELD

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Returns Calculation Returns are calculated in the following manner (example): Say, the fund house comes to an initial value of the Nifty, which is often the average of the first 3 months Also suppose, the Niftys value has been 4,800, 5,000 and 5,200 at the end of months 1, 2 & 3: o Their average is worked out to be 4800+ 5000 + 5200/3 = 5,000 The final value is also calculated as the average of the last three month Now, if the Niftys value closes at 7,000, 7,200, 7,500 in months 34, 35 and 36 respectively, we can calculate the average to 7,233 So, the final Nifty returns come out to 7,233 -5,000/5,000*100 = 44.67% over 3-yr period ELD returns will be: Nifty return multiplied by the participation ratio (that is pre-decided by the fund) is the final return o If Participation Ratio is 120% then ELD returns would be 120%*44.67%(Nifty Returns) = 53.60% over 3yrs

Frequent Terms Used:

Participation Ratio is the ratio at which ELD participates in the appreciation of the underlying equity index (eg Nifty) o E.g. Participation Ratio of 100% implies that a 10% increase in the Nifty will result in a final equity-linked coupon of 10% Knockout/Barrier levels: It is a predefined level. These levels cap the participation in underlying index. Once these levels are achieved/hit, then predefined % participation will be given o E.g. Barrier level is 180% & Knockout returns is 60%, which means if Nifty gains by more than 80% as per closing/final NAV/Value, then participation ratio will be void and knockout returns of 60% will be paid to investors

Risk
Issuers risk: Some times the issuer may offer to buy back the notes at a certain cut off Credit risk: Predominant investments in instruments issued by NBFC, hence credit rating of the instruments may add the risk Liquidity risk: Liquidity in ELD is very limited hence difficult to sell in the market & ELD do not allow premature exit Market risk: In case Nifty does not appreciate the investors can get negligible returns All benefits are subject to investment being held till redemption date Equity linked debenture schemes do not allow premature exits

Sutiablity
Investors seeking higher returns than conventional fixed income products with controlled risk can invest into the ELD

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