Factiva

For investors still smarting from any bear-market-related trauma, several new stock-debt hybrid products have hit the market in recent months, offering some downside protection.

These equity-linked notes are essentially interest-bearing bonds that are linked to an underlying stock. Once the notes mature -- assuming they haven't been called early -- holders will receive shares of the underlying stock based on a predetermined exchange ratio. The trade-off? Though your downside is cushioned by the interest payment -- typically in the 8% to 10% range -- your potential for investment gains is capped.

"You are in effect loaning money to the firm, and what you will get in return is based on the performance of an underlying stock the firm chooses," said Richard Mikaliunas, head of the capital-markets group at the American Stock Exchange, where the majority of these notes are listed.

These products are geared for more conservative individual investors looking to preserve their capital, but who, at the same time, still want to keep a toe dipped in the stock market. Of course, they should also find the underlying stock attractive.

"These were not very popular when the market was roaring, [though in] the past couple of years they have come back into favor," Mr. Mikaliunas added.

The notes, which have existed for about a decade, are issued by many of the large Wall Street firms such as Morgan Stanley, Merrill Lynch & Co. and Citigroup Inc., to name a few. The notes' inherent risk is tied to the health of the underlying issuer.

Morgan Stanley recently issued what it calls "SPARQS", or Stock Participation Accreting Redemption Securities, tied to Yahoo Inc. and Avaya Inc., while Merrill Lynch recently issued its product, called "STRIDES," or Stock Return Income Debt Securities, tied to Sony Corp.'s American depositary receipts. A full roll of recent offerings listed on the American Stock Exchange can be found under the structured-products tab at www.amex.com, along with other structured-product offerings.

Here's how they work, using Morgan Stanley's 10% SPARQS exchangeable for shares of JetBlue Airways as an example (they expire on June 15, 2005).

In this case, the JetBlue SPARQS -- equity-linked notes traded like stocks -- cost $14.15, which is equal to half of the stock's official close on May 21, when they were initially offered for sale. The notes pay 10% interest on the principal amount -- it's paid quarterly, beginning Sept. 15 -- and at maturity, investors receive half a share of JetBlue for each SPARQS held. However, investors' total returns, including interest, cannot exceed 34%.

Investors do run the risk of having their notes called early, cutting their potential earnings short. In the case of the JetBlue SPARQS, all of the SPARQS can be called at any time beginning Nov. 30. Holders would be paid the amount of interest that has accrued during the period they held the notes, along with a predetermined call price.

Investors must also be mindful of the fact that they don't actually own the shares. So if a particular stock began paying a dividend, equity-linked note holders wouldn't benefit.

Though it doesn't apply to the JetBlue SPARQS example, equity-linked notes in some cases don't pay investors interest until they mature. It's best to hold those in a tax-deferred account, such as an IRA, because Uncle Sam doesn't want to wait for his money. Indeed, investors have to pay tax on the so-called estimated phantom income that they are expected to receive at the end of the note's term, before they actually receive it.

Maturity dates typically run between one and three years, while the notes' prices relatively track the price of the underlying stock, Mr. Mikaliunas said. Regular investors should be able to trade the notes easily. But large institutions looking to trade 5,000 share blocks could run into liquidity problems; the instruments are not geared for that market, he added.

Meanwhile, many of these equity-linked products can be similarly re-created by individual investors through the purchase of the stock and call options. However, that could become pricey for the smaller investor, given that they would be paying for the call, in addition to the commissions. Doing it yourself also doesn't provide the interest income.

"None of these are beyond the more sophisticated investors, but you have to go out and do it," Mr. Mikaliunas said. "The other part is that it becomes too commission intensive for the smaller investor, and that can [eat] away at your return."

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