What are Equity-Linked Securities (ELKS)?
As the name implies, equity-linked securities (ELKS) are hybrid debt securities whose return is connected to an underlying equity (usually a stock). ELKS pay a higher yield than the underlying security and generally mature in one year. At maturity, these securities will pay back the original principal, or if the linked equity has fallen below a pre-determined price, then the ELKS will convert into shares of the underlying security.
How Do Equity-Linked Securities (ELKS) Work?
One of the most distinguishing ELKS characteristics is that the size and nature of the principal repayment is determined by the linked stock's price. For example, if Company XYZ stock was $10 per share when the ELKS were issued, then ELKS investors will receive their principal back in cash only if Company XYZ's stock price stays above, say, 80% of $10 per share (or $8 in this case) while the ELKS are outstanding. If the price of Company XYZ stock goes below $8 at any time during the life of the ELKS, then the investors receive a predetermined number of Company XYZ shares (say, a quarter of a share of Company XYZ for every ELKS they hold) rather than cash when ELKS mature. The value of XYZ shares the investor receives at maturity could be worth more or less than what the investor initially invested.
There are two tax benefits to ELKS. First, part of the coupon payments are usually treated as the payment of an option premium rather than interest income, meaning that investors do not have to report those portions of the payments as income until the ELKS mature. Second, if the investor receives stock rather than cash when the ELKS mature, then that portion of the payment associated with the option premium reduces the investor's stock basis and is not included in income.
Another distinguishing characteristic is that ELKS are a registered trademark of Citigroup Funding, Inc., because Citigroup is actually the issuer of ELKS. They are unsecured debt obligations of Citigroup Funding, Inc., not the underlying stock issuer, and Citigroup guarantees the interest and principal payments, not the stock issuer. Citigroup lists its ELKS on the major exchanges, which gives them some level of liquidity. However, this also means that ELKS may trade at prices below their original issue prices.
Why Do Equity-Linked Securities (ELKS) Matter?
Like convertible bonds, ELKS are hybrid securities; that is, they share the characteristics of both stocks and bonds. With a convertible bond, however, the bondholders can participate in the company's stock price appreciation because the higher the market value of the underlying shares goes, the more the bond trades like a stock. But this upside is limited with ELKS; the investor instead simply collects his interest payments and gets the privilege of receiving his principal back in cash when the ELKS mature. Thus, his return is limited to the coupon rate.
Likewise, convertible bondholders are somewhat protected from steep stock price declines: during those times, they still receive their interest and principal payments and have priority over the company's stockholders. But ELKS do not offer this principal protection. If the price of the underlying stock declines, the investor could theoretically receive a pile of worthless stock instead of a cash principal repayment. Furthermore, because Citigroup is the issuer, the ability and willingness to repay the debt rests with Citigroup, not the issuer of the underlying stock (although Citigroup is more creditworthy than some of the stock issuers). Thus, ELKS remove one of the most basic safety nets bond issuers give to their investors -- the promise of principal repayment. These risks are primarily why ELKS usually pay a higher fixed coupon than similar convertible debt and usually yield more than the stock on which they are based.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
When I went to kindergarten, it didn’t take me long to get in trouble. At the very first parent-teacher meeting, my mother was informed that I was quite a little talker in class. My teacher...Read More →
Many investors turn to mutual funds because the funds can make it fairly easy to see solid returns while maintaining a degree of diversity. Unfortunately, there...Read More →