Half of ELS contracts linked to H shares at risk of losing principal for Koreans

[Photo by Lee Seung-hwan]

Around half of equity-linked securities (ELS) with underlying mainland Chinese stocks listed on Hong Kong market are already losing money for South Koreans as the Hong Kong stock index crashes to a 14-year low with China’s leader Xi Jinping entering the third term.

ELS connected to the Hang Seng China Enterprises (HSCEI) sold about 10.4 trillion won ($7.2 billion) worth in Korea this year.

Half of them are projected to have entered the knock-in option zone where investors may lose their principal investment, according to Korea Investment & Securities and other industry sources on Monday.

An ELS is a hybrid financial derivative whose return moves in line with the price of a particular stock or index. ELS products are considered a medium-risk financial instrument because they give back investors their principal and extra returns when their linked assets move between the knock-in and knock-out barriers upon maturity. But when the base stock index or single stock dips below the knock-in line before maturity, investors may suffer huge losses.

HSCEI ELS is linked to HSCEI, which is comprised of H-shares, referring to the shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange, and Red-chip, referring to stocks of mainland China-based companies largely controlled indirectly or directly by the Chinese government.

The knock-in line for most HSCEI ELS products sold in Korea is set at between 5,000 and 6,000, meaning that investors would lose even their principal investment when the HSCEI dips below 6,000.

HSCEI has tumbled nearly 36 percent so far this year. It was trading at around 5,075 on Tuesday morning. Its performance is worse than Korea’s Kospi and mainland China’s Shanghai Composite Index, which lost 25 percent and 27 percent, respectively, over the same period. Its underperformance is largely owed to global central banks’ aggressive tightening moves, the Chinese government’s strict antitrust regulations especially against its tech companies, and Xi Jinping confirming his third term as leader of China.

If the index falls below 5,000, the combined loss for Korean investors would reach 5.7 trillion won from their investment in HSCEI ELS products. The estimated loss amounted to an estimated 2.5 trillion won when the HSCEI plunged below 5,500, according to Korea Investment & Securities.

According to Baek Doo-san, analyst at Korea Investment & Securities, 2.5 trillion won worth of HSCEI ELS contracts held by Korean investors have knock-in options set at or above 5,500, representing 26 percent of the total, while those with the knock-in option set between 5,000 and 5,500 amount to 3.2 trillion won, accounting for 30 percent.

The Hong Kong index-linked exchange-traded funds (ETFs) also face a risk of huge losses.

KODEX China H Leverage(H), designed to generate profit when the HSCEI index rebounds, has lost 62 percent so far this year, due to a plunge in H shares. In contrast, KBSTAR China H Futures Inverse(H) ETF, which bets on a fall in underlying H shares, surged 35 percent.

Citing Hong Kong index’s low price-to-book ratio (PB ratio) of below 1x, some analysts expect a rebound in Hong Kong stocks in the first half of next year.

Korean investors’ appetite for ELS products is, however, dwindling due to the poor performance of H shares and Hong Kong shares.

In the third quarter, 6.03 trillion won worth of index-linked ELS were issued, down 68.3 percent compared to the fourth quarter of 2021.

The balance of ELS funds that are not redeemed recorded 68.7 trillion won in the third quarter, up 30 percent versus a year ago.

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