Equity Linked Debenture

An ELD is a bond wearing an equity costume. The investor lends money to the issuer, as with any debenture, but instead of a fixed coupon the payoff is linked to how the Nifty 50, the Sensex, an individual share or a customised basket of shares performs over the term.

The attraction is the shape of the payoff: the principal is structured to come back whatever the market does, while a share of any rise is passed through. The cost of that shape is the return that was given up to buy it.

The issuer splits the money it receives into two pots.

Pot one goes into fixed income securities such as bonds, sized so that it grows back to the full principal by maturity. That is where "capital protection" comes from — it is arithmetic, not a guarantee.

Pot two is whatever is left over, and it buys options that deliver the equity exposure. Because pot two is small, the investor gets only a fraction of the index's move, not all of it.

The workbook is careful on two points. First, capital protection should not be read as the absence of credit risk — if the issuer defaults, both pots go with it, which is why ELDs are rated by credit rating agencies like any other debenture. Second, it notes the issuer's side of the trade: a company that raises ELD money intending to spend it on capital expenditure finds very little left for capex once the protection leg and the options have been paid for.

Zero-coupon leg today = Principal ÷ (1 + market yield)^n

Option budget = Principal − Zero-coupon leg − issuer fees

Maturity payout = Principal × [ 1 + participation rate × index return ]
                  (subject to the principal floor)

An investor puts Rs 10,00,000 into a 5-year Nifty-linked ELD from a AAA issuer, when 5-year bonds of that quality yield 7.5%.

To be certain of returning Rs 10 lakh in five years, the issuer must set aside

10,00,000 ÷ 1.075^5 = 10,00,000 ÷ 1.4356 = Rs 6,96,559

That leaves Rs 3,03,441, less fees, to buy five-year call options on the Nifty. Assume those options buy a 70% participation in the index's rise. Three outcomes:

Compare each with simply buying the AAA bond, which turns Rs 10 lakh into Rs 14,35,629.

In the first case the protection cost the investor Rs 4,35,629 of certain interest. In the second, a 60% rise in the Nifty still left the ELD marginally behind the plain bond. Only the third case pays for the structure. Capital protection is not free; it is paid for out of the return.

Chapter 2 (Introduction to Securities Market, section 2.2.7.5) lists ELDs among hybrid and structured instruments. The examinable points are the construction — part of the principal into fixed income for protection, the balance into options for equity participation — and the warning that capital protection does not remove credit risk.

• "Capital protection" is a structure, not a guarantee. The workbook is explicit that ELDs still carry credit risk and are credit rated. Issuer default defeats the protection.
• The workbook calls an ELD a floating rate instrument — but the rate floats with an equity index, not with a money market benchmark such as MIBOR.
• Participation is a fraction of the index move, because only the leftover after funding the protection buys options. A 60% index rise does not mean a 60% return.
• An ELD holder owns a debenture, not shares — no voting rights, no dividends from the index constituents, no name on a register.
• The protection applies at maturity. Selling before then gets whatever the market pays for the bond leg plus the option leg on that day.
• The issuer's problem is examinable too: raise capex finance through an ELD and most of the money is consumed by the protection and the option premium before any plant is built.