Equity Index-Linked Notes

Equity index-linked notes come up when a distributor explains the redemption amount and the risks to customers, and when financial institutions assess and manage the risks of investing in structured products.

A bond whose redemption depends on an equity index

An equity index-linked note is a bond whose redemption amount at maturity or coupon changes with the movement of an equity index. On the Nikkei Stock Average-linked notes sold in Japan, the redemption amount or interest rate changes with factors such as the percentage change in the Nikkei Stock Average from a reference date¹. The redemption amount is set by a formula that applies the change in the index to the face value, and it is paid in cash². This is where the note differs from an exchangeable bond (EB), which is linked to the share price of a single company and may be redeemed in shares.

Equity index-linked notes come in two broad types. The first is the so-called principal-protected note, whose terms provide for redemption at face value if you hold it to maturity. The face value is repaid in the currency of the note, and the issuer's credit risk and, for a note in a foreign currency, currency risk remain (see the section "Issuer credit risk and the risk of selling before maturity" below). Most principal-protected notes combine a zero-coupon bond with a derivative such as an option linked to the equity index³. A zero-coupon bond pays no coupon and is issued at a price below its face value⁴. Most structured notes sold in the United States have no principal protection⁵. The second type is the note with a knock-in feature. If the index falls to a level set in advance (the knock-in price), the note knocks in, and the redemption amount then moves with the index and falls below face value if the index at maturity is below the initial price¹.

The idea of viewing a structured note as a bond plus derivatives is covered in What Are Structured Products?. The value of the Nikkei Stock Average when the terms are set is called the initial price. Consider a hypothetical example in which Company D issues two notes linked to the Nikkei Stock Average, with an initial price of 10,000 yen.

Redemption of a principal-protected note

On a principal-protected note, if the index rises, an amount in line with the rise is added to the face value. This example uses a simple form in which the added amount depends only on the index at maturity. Company D's principal-protected note has a face value of 1 million yen, a term of five years, and no coupon. The redemption amount at maturity is the face value of 1 million yen plus 1 million yen × 50% × the rise in the index (nothing is added if the index falls). The share of the index's rise that is passed on to the investor, 50% in this case, is called the participation rate⁶.

If the index is 14,000 yen at maturity, half of the 40% rise, or 20%, is added, and the redemption amount is 1.2 million yen. Even if the index is 8,000 yen at maturity, the redemption amount is the face value of 1 million yen. However, because you receive no coupon for five years, you receive less than if you had held an ordinary bond for the same period. If the index at maturity is not above the initial price, nothing is added, and the return falls short of that on an ordinary fixed-rate bond of the same term. It can fall well short⁷.

Figure description

The amount added to the face value of 1 million yen at maturity on Company D's principal-protected equity index-linked note (face value 1 million yen, participation rate 50%, initial price 10,000 yen). The horizontal axis shows the Nikkei Stock Average at maturity, and the vertical axis shows the added amount. If the index at maturity is 10,000 yen or below, nothing is added, and the redemption amount is the face value of 1 million yen. Above 10,000 yen, the added amount rises by 50 yen for each 1-yen rise in the index, reaching 100,000 yen at 12,000 yen, 200,000 yen at 14,000 yen, and 300,000 yen at 16,000 yen. Even if the index falls below the initial price, the added amount never becomes negative.

The shape of the added amount in Figure 1 is the same as a long call option on the index with its strike price at the initial price. A principal-protected note can therefore be seen as a combination of a zero-coupon bond that repays the face value of 1 million yen at maturity and a long call on the index. Suppose Company D's five-year zero-coupon bond is priced at 900,000 yen. The remaining 100,000 yen of the 1 million yen the investor pays would go toward the price of the call (the option premium) and costs. Some principal-protected notes also cap the added amount, which limits what the investor can receive⁶.

Redemption of a note with a knock-in feature

On a note with a knock-in feature, if the index falls to or below the knock-in price at any time during the term, and the index at maturity is below the initial price, the redemption amount falls below face value². Company D's note with a knock-in feature has a face value of 1 million yen, a term of three years, a coupon of 3% a year (30,000 yen each year), and a knock-in price of 6,000 yen. If the note knocks in, the redemption amount at maturity is 1 million yen × the index at maturity ÷ the initial price of 10,000 yen, and if the result exceeds 1 million yen, the amount is 1 million yen. This example leaves out automatic early redemption.

In case A, the index at maturity is below the initial price, but the note has not knocked in, so it is redeemed at the face value of 1 million yen. In case B, the note has knocked in, but the index at maturity is above the initial price, so the redemption amount stays at the face value of 1 million yen. Even though the index has risen 20%, the redemption amount does not exceed face value. In case C, the note has knocked in and the index at maturity is 7,000 yen, so the redemption amount is 700,000 yen. Adding three years of coupons, 90,000 yen, brings the total to only 790,000 yen, and the investor loses 210,000 yen.

The way the redemption amount falls in case C matches the payment on a sold put option on the index with a strike price of 10,000 yen, for 1 million yen of face value. A put that takes effect only after the note knocks in is called a knock-in put. Through the note, the investor has in effect sold a knock-in put. This decomposition and its payoff diagram are covered in Exchangeable Bonds (EB), which are linked to individual shares.

Many Nikkei Stock Average-linked notes have an automatic early redemption (autocall) clause, under which the note is redeemed before maturity if the index is at or above an early redemption trigger level¹. Once the note is redeemed early, there is no longer any chance of a knock-in, but from then on you cannot earn the yield you originally expected⁸.

How the coupon is set

Investors in principal-protected notes may be giving up a higher yield in exchange for redemption at face value⁹. The principal-protected note in the example above has no coupon, and 100,000 yen, the equivalent of five years of interest (the difference between the face value of 1 million yen and the zero-coupon bond price of 900,000 yen), goes toward the price of the call and costs. If the index at maturity is at or below the initial price, nothing is added, and the investor does not receive this equivalent of interest.

A note with a knock-in feature is redeemed at face value if it does not knock in, and a higher yield than that of an ordinary bond of the same term can be expected¹⁰. The higher coupon is the premium the investor receives in return for selling an option¹¹. The larger the gap between the knock-in price and the current index, the less likely a knock-in and the lower the coupon; the smaller the gap, the higher the coupon¹². In the example above, raising the knock-in price from 6,000 yen to 8,000 yen would make a knock-in more likely, so the coupon would be set higher than 3% a year.

On some notes, the coupon itself changes with the index. If the index on the rate-setting date is at or above a reference price, a higher rate applies; if it is below, a lower rate applies¹.

Issuer credit risk and the risk of selling before maturity

With an equity index-linked note, changes in the issuer's financial condition may delay payments of principal or interest, or lower the price of the note¹³. The note may also be hard to sell before maturity, and even if it can be sold, the sale price may be below face value, which could result in a loss¹⁴. Both risks are common to structured products.

On a principal-protected note, these two risks bear on the principal protection itself. The promise to redeem at face value is only as good as the issuer's creditworthiness, and if the issuer fails, you may lose much of your investment¹⁵. The principal protection usually applies only if you hold the note to maturity¹⁶. The issuer has no obligation to buy the note back before maturity, and even when it agrees to, the price may be well below face value¹⁷.

In addition, on an equity index-linked note denominated in a foreign currency, the amount converted into yen can end up smaller than what you invested because of exchange rate moves, causing a loss¹⁸. A principal-protected note also protects only the face value, not your purchasing power against rising prices¹⁹.

Notes

1. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (What are the features and risks of Nikkei Stock Average-linked notes?, in Japanese), page 1, "１．そもそも日経平均リンク債とは？" (1. What is a Nikkei Stock Average-linked note?). ↩ ↩² ↩³ ↩⁴

2. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), pages 5–6, "【条件例】" (Example terms) in "３．日経平均リンク債の償還について" (3. Redemption of Nikkei Stock Average-linked notes). ↩ ↩² ↩³

3. FINRA, "Regulatory Notice 09-73" (December 2009), page 1, "Background and Discussion." ↩

4. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (February 1998), Section 4045.1, "Corporate Notes and Bonds," page 2, "Zero-Coupon Bonds." ↩

5. FINRA, "Understanding Structured Notes With Principal Protection" (April 12, 2023), "How Do These Notes Protect My Investment?" ↩

6. FINRA, "Understanding Structured Notes With Principal Protection" (April 12, 2023), "How Do These Notes Calculate the Return on My Investment?" and the second-to-last paragraph of "Can I Get My Money When I Need It?" ↩ ↩² ↩³

7. The same article, the first paragraph of "Performance and Cost Considerations." ↩

8. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 2, "注意すべき事項" (Points to note). ↩

9. FINRA, "Regulatory Notice 09-73" (December 2009), page 6. ↩

10. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 1, "魅力" (Attractions). ↩

11. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), page 3, "１．仕組商品とは" (1. What structured products are). ↩

12. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 3, the note on "利率（クーポン）" (Interest rate (coupon)). ↩

13. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 3, "発行者の信用リスク" (The issuer's credit risk). ↩

14. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 7. ↩

15. FINRA, "Understanding Structured Notes With Principal Protection" (April 12, 2023), the last paragraph of "How Do These Notes Protect My Investment?" ↩

16. FINRA, "Regulatory Notice 09-73" (December 2009), page 2. ↩

17. FINRA, "Understanding Structured Notes With Principal Protection" (April 12, 2023), "Can I Get My Money When I Need It?" ↩

18. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 6, "日経平均リンク債に特有のリスク" (Risks specific to Nikkei Stock Average-linked notes). ↩

19. FINRA, "Regulatory Notice 09-73" (December 2009), page 6. ↩