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Equity linked security, or ELKS

This month, we’re spotlighting something a little different—an equity linked security, or ELKS, as recommended by Carla Pasternak of StreetAuthority’s High-Yield Investing. ELKS are hybrid debt securities whose return is linked to the performance of an underlying equity. They pay a higher yield than the underlying security, usually in two...

This month, we’re spotlighting something a little different—an equity linked security, or ELKS, as recommended by Carla Pasternak of StreetAuthority’s High-Yield Investing. ELKS are hybrid debt securities whose return is linked to the performance of an underlying equity. They pay a higher yield than the underlying security, usually in two predetermined payments before their maturity. At maturity (which is usually after one year) investors get their original principal back, unless the linked equity has fallen below a pre-determined price, in which case the ELKS will convert into shares of the underlying security.

“This month we went hunting for ELKS. And did we track down a trophy! It’s an Equity-Linked Security that’s linked to the price of one of the strongest bank stocks in America. Plus this ELKS comes with an outstanding yield of close to 10%. That’s based on guaranteed payouts of nearly $1.00 over the next nine months. On an annualized basis, the yield is an astounding 12.5%. Not bad when you consider that a one-year CD is paying just 1.5%! Nor is the payout your ordinary discretionary dividend. It’s senior debt, a contractual obligation which must be paid or the issuer could risk a credit downgrade.

“High-yield and reasonable-risk can be like oil and water—they tend not to mix. But this hybrid security offers just such a rare combination. It trades daily on the New York Stock Exchange like any stock, but offers the secure income of a senior bond. And when it expires in late November, it will return some or all of your investment capital either as cash or common shares of the bank.

“Citigroup, Inc. ELKS on Wells Fargo & Co. (ESK 10.79 NYSE - yield 9.4%) is linked to the price performance of the common stock of Wells Fargo (NYSE: WFC), the nation’s fourth-largest bank. The ELKS was issued in late October at a par value of $10 per share and matures on November 24, 2010. If held to maturity, one of two things will happen. The first possibility is that investors will receive back the $10 principal in cash per share, or have the option to receive the same value in Wells Fargo common stock. The second possibility is that investors will receive 0.34106 shares of WFC if, at any time during the life of the ELKS, the price of WFC is equal to or less than $19.06 (65% of the $29.32 price of Wells Fargo on ESK’s issue date).

Yield

“ESK will pay a total of $0.965 per security in 2010, giving a beefy 9.4% yield at today’s price. Payments will be made in two installments: $0.515 on May 24, 2010 and $0.45 on November 24, 2010. The payments will be made to holders of record on the third business day prior to the payment dates. Payments comprise $0.134 in interest income on an underlying bond and $0.831 in option premiums. Both are taxable at ordinary income tax rates, making ESK appropriate for tax-deferred accounts. It’s important to note that these interest and principal payments are guaranteed by Citigroup Funding, a subsidiary of Citigroup (NYSE: C), not Wells Fargo. These ELKS are a senior debt issue of Citigroup, which means that payments should be made before any payment on common or preferred stock. Things have dramatically improved at Citigroup since the darkest days of the financial crisis. Credit rating agencies now assign Citigroup senior debt issues the high-quality investment grade ratings of A3 (Moody’s) and A (Standard & Poor’s), indicating strong safety.

Performance

“Since Wells Fargo has remained well above the $19.06 ‘trigger’ price since the ELKS were created, shares of ESK have remained stable. Some investors may paint Wells Fargo with the same brush as other banks that helped bring on the financial crisis. However, Wells was one of the few responsible banks that didn’t overindulge in risky loans. Of course, even Wells experienced some pain in the bear market, but it now appears to be even stronger coming out of it. ... For the fourth quarter, the bank earned $394 million or $0.08 per share, when analysts polled by Thomson Reuters were expecting a loss of $0.01 per share. ...

“Of course, what matters most to ESK investors is whether the stock price will dip below $19.06. For now, it appears unlikely. Wells’ shares are trading today at $28.01, and would have to fall 32% to hit the trigger price. Given that the worst seems behind the bank, I’m reasonably confident this sort of drop won’t occur before maturity. The good news is that in a worst-case scenario, your ELKS would convert into shares of one of the nation’s best banks, which over the long term should be a good investment.

“I believe this is a strong example of reward outweighing the risks. I plan to add ESK to the ‘Dividend Optimizer’ Portfolio. ... Just to be safe, I will set a ‘stop’ on WFC common shares at $19.20. In other words, if WFC hits my stop price, I will sell ESK at its market price at that time. You may wish to do the same. Also, since trading on this security is relatively illiquid, you may want to add the security in small lots so as not to push up the price.”

Carla Pasternak, High-Yield Investing

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.