Korean ELS investors anxious about further fall in Hong Kong stock index

The amount of Korean equity-linked securities (ELS) and other derivative products tracking the Hang Seng China Enterprises Index (HSCEI) in Hong Kong facing maturity next year is estimated to reach 14 trillion won ($10.87 billion). Most of these products were issued before the significant decline in the index in 2021, raising concerns about potential principal losses if the index experiences further drops before the maturity date.

According to the Korea Securities Depository (KSD) data on Friday, the outstanding balance of ELS linked to the HSCEI stood at 20.69 trillion won ($16.05 billion) as of June this year, marking an increase of around 5 trillion won compared to 15.5 trillion won in January 2021. It has also grown by about 400 billion won since the beginning of this year.

The increase in the outstanding balance is attributed to the fluctuations in the prices of the underlying assets in ELS products, which have led to failure in meeting the early or midterm redemption requirements.

The outstanding balance of HSCEI-tracking ELS products reached 26 trillion won in 2020, then sharply declined in early 2021, but it has been increasing again with the subsequent plunge in the index.

ELS are derivative products whose returns are determined based on the performance of underlying assets, such as an index or individual stocks. Typically, these products mature after three years and offer early redemption opportunities every six months, based on the evaluation of the underlying asset’s price.

Investors in ELS products are entitled to receive the promised returns from the issuer if the underlying asset’s price does not fall below a certain level (knock-in level) until maturity.

Currently available products indicate an expected pre-tax annual return of 6-8 percent. The knock-in levels, at which losses occur, vary between 45-65 percent, depending on the specific product.

Many of the ELS products linked to the HSCEI are set to mature next year, with estimates indicating a combined amount of 13.9 trillion won. In particular, 3.8 trillion won and 5.2 trillion won worth of ELS products are expected to mature in the first and second quarters of next year, respectively, according to Samsung Securities.

The popularity of ELS products tracking the HSCEI is due to the expectation of high returns. ELS investors are looking for high returns, and the inclusion of the volatile HSCEI increases the expected return, so there is a high demand for related products. Nowadays, banks tend not to sell products that include the index because of the risk, so there are not many recent issues, experts say.

To mitigate risks, ELS products usually diversify by including around three underlying assets. If any of the underlying assets breach the knock-in level, the final payout on the maturity evaluation date will be determined based on the fulfillment of the redemption condition. If any of the underlying assets fail to meet the redemption condition, the loss will be fixed according to the decline in the value of that particular asset.

One noteworthy development is the emergence of ELS products tracking the HSCEI in the second half of 2020, which are now approaching their knock-in levels.

While the index traded around 10,000 to 12,000 points at the end of 2020, it has currently dropped to around 6,400 points. ELS products with a knock-in level at 55 percent will enter the zone if the index experiences an additional decline of only 9-10 percent.