30% Yield ELS, Opportunity or Trap: Market Changes and Investment Strategies After the Hong Kong H-Index Incident

Kim Jeong-hyuk, Team Leader at Meritz Securities, explained that while ELS is not suitable for all investors, it can be useful in specific situations. He added that the downside protection feature of ELS can be attractive to investors who have an attachment to certain stocks but feel anxious about downside risk. For example, for those who have invested in or are considering investing in stocks like Hynix and are confident that 'it will definitely rise to 5 million won,' ELS with limited upside profit is not suitable. However, for investors who 'love Hynix but are worried it might fall by -50%,' ELS that protects the downside can be a good option.

Recently popular 'knock-in' products act as a barrier to prevent principal loss, helping to alleviate investor anxiety.

In the past, the ELS market was dominated by bank trust channels, accounting for 70-80% of total sales. However, after the sharp decline in the Hong Kong H-index led to massive principal losses, ELS sales significantly contracted, and the market structure changed. Currently, most banks have stopped selling ELS, leading to a significant expansion of securities firms' retail channels. This is analyzed as an unavoidable change due to banks no longer actively selling ELS.

While other banks significantly reduced ELS sales during the Hong Kong H-index crisis, Woori Bank was relatively unaffected. This was because Woori Bank had very few H-index linked ELS sales to begin with. At the time, Woori Bank internally judged it better to reduce exposure to China and primarily sold products linked to KOSPI, S&P, and Eurostoxx instead of Hong Kong H-index products. Nevertheless, as a major house that sold ELS worth 6-7 trillion won annually, it wasn't selling small amounts. As a result, Woori Bank remains almost the only bank channel selling ELS, earning it the reputation of a 'thankful bank channel' in the securities industry.

The underlying assets of ELS are broadly divided into index-type and individual stock-type. Currently, index-type ELS only utilizes four indices: KOSPI 200, Nikkei 225, Eurostoxx 50, and S&P 500. Previously, the Hong Kong H-index was also included, but after the recent large-scale loss incident, securities firms felt significant pressure to use the H-index and excluded it from underlying assets. This is an important point showing a change in product structure. This change is interpreted as part of efforts to protect investors and ensure market stability.

ELS product conditions have significantly eased over the past year. Products sold in June last year offered a 7% annual yield with a knock-in barrier of 40%, but this June, products offering a 22.4% annual coupon rate were launched with an even lower condition of 35%. This means that the lower knock-in barrier reduces the possibility of principal loss.

Additionally, the number of observation events for early redemption has increased from 6 to 9, giving investors more 'second chance' opportunities. The phenomenon of relaxed conditions and increased observation frequency, despite coupon rates more than tripling, is interpreted as a result of increased market volatility premium. This provides investors with more attractive returns but also suggests that it may reflect market instability.

Team Leader Kim Jeong-hyuk explained the recent phenomenon of lower ELS product barriers and higher coupon yields. In response, the host raised a question as to whether the higher coupon yield despite relaxed barrier conditions reflects people's assessment of the market as unstable and their expectation that prices could fall significantly. In other words, the question was whether the market is predicting high volatility and therefore reflecting a higher risk premium in ELS coupon rates.

Some investors suspect that if ELS incurs losses, securities firms profit from the opposite position. In response, Team Leader Kim Jeong-hyuk explained that securities firms also hedge against market volatility through hedging operations after selling ELS products. He emphasized that since securities firms use various derivative products to hedge and reduce position risk from ELS issuance, it is not a simple structure where investor losses directly translate into securities firms' direct profits.

Team Leader Kim Jeong-hyuk explained that recent ELS product conditions have significantly improved compared to before. For example, in the past, profits were paid if the knock-in barrier did not fall below 40%, but recently, conditions have become more lenient, requiring it not to fall below 20-30%. Logically, if the barrier is much lower, the interest rate should also be lower, but in reality, coupon rates have increased. The host raised a question about the background of these conflicting changes and requested a detailed explanation.

ELS coupon rates are not standardized like bond markets but vary by securities firm. This is because each securities firm uses its own model to predict various parameters such as volatility, dividends, and correlation coefficients, and determines coupon rates based on these. Volatility forecasts are the most important, but other factors also influence coupon rates. Therefore, even for ELS using the same underlying assets, the coupon rates offered by different securities firms can vary, suggesting that this can depend on each firm's market prediction capabilities and operational strategies.

Due to investor protection regulations, ELS experiences a 2-3 week time lag from product bidding to actual sale. This time lag can lead to traders unexpectedly earning significant profits or, conversely, incurring large losses. For example, if a trader participates in a bid expecting a 20% yield, but market conditions change two weeks later, allowing for a 30% yield, the trader earns a substantial profit. Conversely, if they expected a 40% yield but market volatility decreases to 20% two weeks later, they incur losses.

This time lag directly affects traders' operational performance depending on market volatility and exacerbates the complexity of ELS issuance and hedging operations.

The current ELS market is a 'perfectly competitive market' where 10-15 securities firms launch products weekly, competing fiercely. In this competitive environment, it is realistically difficult for a specific securities firm to continuously lower interest rates in its favor when launching products. Securities firms have no choice but to determine interest rate levels by closely monitoring bloggers' analysis and market sentiment. This is an essential process to prevent customer attrition and maintain market competitiveness. Therefore, ELS coupon rates are not unilaterally decided by securities firms but are formed under the influence of market competition and public opinion.

ELS and ELB (Equity-Linked Bonds) have similar profit structures, but the biggest difference is whether the principal is guaranteed. ELB is a guaranteed product, designed to pay the principal if certain conditions occur (e.g., the underlying asset falls below a certain level). It is described as seeking 'preservation' rather than 'guarantee.' ELS, on the other hand, is an unguaranteed principal product, where principal loss can occur due to price fluctuations of the underlying asset.

Additionally, ELB guaranteed products often only pay the principal upon redemption, while ELS generally pays both the principal and the promised coupon profit upon early redemption. For example, ELS is evaluated every 6 months, and if redeemed, investors receive the principal along with the promised 3% coupon (assuming 6% annually), but ELB often only pays the principal upon redemption.

Regarding the high utilization of Samsung Electronics as an underlying asset in ELB products, Team Leader Kim Jeong-hyuk explained that it is related to the customer preferences of specific banks. Banks consider various underlying assets such as Samsung Electronics, Hynix, and KOSPI when receiving monthly approval for non-deposit product limits. However, customers of certain banks tend to prefer Samsung Electronics over Hynix, which has higher volatility, even among the leading stocks of KOSPI 200. This is because Samsung Electronics is judged to be less likely to fall by 40-60% in a month compared to Hynix. In other words, the preference for relatively stable large-cap stock Samsung Electronics is high, intertwined with ELB's characteristic of seeking principal preservation.

Recently, the dominant ELS investment strategy has shifted to a 'short-term' approach rather than a long-term one. This is a strategy to avoid long-term investments with low liquidity in situations of high short-term market volatility and actively utilize early redemption opportunities. Team Leader Kim Jeong-hyuk explained that for products with a 3-year and 3-month maturity, early redemption possibilities are increased through 12 observations every three months. For example, 'KOSPI Single' type products have high exercise prices but knock-in barriers set at 65%, 65%, 55%, etc., allowing for early redemption and profit realization if the market does not fall by more than 45% in three months.

This strategy is suitable for investors who want to flexibly respond to rapid market changes and lock in profits early. The analysis suggests that with increased early redemption conditions and observation frequency compared to the past, the short-term strategy has become even more effective.

ELS is largely divided into 'knock-in' and 'no-knock-in' types based on how losses are determined. The no-knock-in structure determines principal loss only by checking whether the underlying asset price exceeds a certain level at maturity, and is mainly sold by banks. The knock-in structure, on the other hand, observes the underlying asset price daily to check whether it falls below a certain barrier, often with additional bonus interest in this case. This knock-in structure is mainly sold by securities firms.

These differences show that product structures are tailored to the customer characteristics and risk preferences of each channel. Bank customers tend to prefer simple and conservative products, thus no-knock-in types, while securities firm customers tend to prefer knock-in products, which are more complex but can expect higher returns.

The complex product structure in the Korean ELS market has been largely influenced by a specific 'convention'. It is explained that as ELS was initially launched with standardized structures in the Korean market, these complex forms became the industry standard. Additionally, it was mentioned that a fixed product structure is advantageous for traders in terms of operational convenience. For example, if a trader has to pay three years of profits at once upon profit redemption, creating 30% profit again when the maturity reaches three years and the price falls below the exercise price can be a burden. Thus, a complex structure that allows early redemption under specific conditions may be preferred.

Following the Hong Kong H-index incident, financial authorities and the securities industry have maintained a very conservative stance on ELS product development and sales. Team Leader Kim Jeong-hyuk revealed that there is a widespread sense of crisis within the industry, with concerns that 'if another loss occurs here, it will be a huge disaster.' Accordingly, a 'Product Selection Committee' is held every month to thoroughly review market conditions, and when certain underlying assets surge, ELS sales are temporarily halted, or knock-in barriers are not set above 30%, focusing on risk management. This is interpreted as the industry's self-correcting effort to prioritize investor protection and prevent a recurrence of past large-scale losses.

For those new to ELS investment, Team Leader Kim Jeong-hyuk advised choosing the product with the lowest coupon rate from the product list. He emphasized that the volatility premium is not 'free' and comes at the cost of bearing that much risk. In other words, a high coupon rate should be seen as a signal that the product has high volatility and can be risky. Therefore, the ELS with the lowest interest rate in the product lineup is the safest product, and one should always be suspicious of products with high interest rates and check their volatility level.

Team Leader Kim Jeong-hyuk suggested ELS investment using a specific stock as the underlying asset as a viable option for investors who hold that stock but are uncertain about selling it now and are waiting for a rebound. For example, if an investor holds Hynix stock but the price is neither rising nor falling, investing in ELS with Hynix as the underlying asset can hedge against a certain level of downside risk. He explained that this can be an alternative to partially defend against losses in a short-term downturn while not missing out on profits from existing holdings when the stock price eventually rebounds. In other words, ELS can be used as a strategy to enhance portfolio stability and alleviate psychological anxiety.

Team Leader Kim Jeong-hyuk stated that he feels remorse and apology on behalf of the securities industry for the investor losses incurred in past ELS products. He added that he personally feels even greater regret as some of his family members have experienced ELS losses. Based on these experiences, the securities industry is undergoing significant self-correction and diligently filtering products, he explained. This demonstrates the industry's efforts to restore investor trust and prevent recurrence.

Some securities firms have introduced policies to halt trading related to specific ELS products when certain conditions occur to strengthen investor protection. Team Leader Kim Jeong-hyuk mentioned that such a system was operated at his previous workplace, explaining that it is a measure to enhance investor protection by prohibiting trading altogether when specific conditions are met and investor losses are expected.

This trading halt system was introduced to prevent accusations of intentional intervention in case of losses and to protect investors from incurring further losses. This is interpreted as an example of the securities industry strengthening its awareness of investor protection.

One of the panelists, Lee Jin-woo, argued that while public perception of ELS might have been 'safe products' in the past, it has completely changed after the Hong Kong H-index incident. He asserted that the massive loss incident has strengthened the perception of ELS as 'products that lead to ruin,' and now almost no one would consider ELS truly safe products. This indicates that market confidence in ELS has been severely eroded, and investors are much more aware of the risks when approaching ELS than in the past.