A credit linked note is a form of funded credit derivative.
It is structured as a security with an embedded credit default swap allowing the issuer to
transfer a specific credit risk to credit investors.
The issuer is not obligated to repay the debt if a specified event occurs.
This eliminates a third-party insurance provider.
It is issued by a special purpose company or trust, designed to offer investors par
value at maturity unless the referenced entity defaults.
In the case of default, the investors receive a recovery rate.
The trust will also have entered into a default swap with a dealer.
In case of default, the trust will pay the dealer par minus the recovery rate, in exchange
for an annual fee which is passed on to the investors in the form of a higher yield on
their note.
The purpose of the arrangement is to pass the risk of specific default onto investors
willing to bear that risk in return for the higher yield it makes available.
The CLNs themselves are typically backed by very highly rated collateral, such as U.S.
Treasury securities.
The Italian dairy products giant, Parmalat, notoriously dressed up its books by creating
a credit-linked note for itself, betting on its own credit worthiness.
In Hong Kong and Singapore, credit-linked notes have been marketed as "minibonds" and
sold to individual investors.
After Lehman Brothers, the major issuer of minibond in Hong Kong and Singapore, filed
for bankruptcy in September 2008, many retail investors of minibonds claim that banks and
brokers mis-sold minibonds as low-risk products.
Many banks accepted minibonds as collateral for loans and credit facilities.
Explanation A bank lends money to a company, XYZ, and
at the time of loan issues credit-linked notes bought by investors.
The interest rate on the notes is determined by the credit risk of the company XYZ.
The funds the bank raises by issuing notes to investors are invested in bonds with low
probability of default.
If company XYZ is solvent, the bank is obligated to pay the notes in full.
If company XYZ goes bankrupt, the note-holders/investors become the creditor of the company XYZ and
receive the company XYZ loan.
The bank in turn gets compensated by the returns on less-risky bond investments funded by issuing
credit linked notes.
Emerging Market CLN The emerging market credit linked note, also
sometimes called a “clean,” are traded by buy side clients to gain access to local
debt markets for several reasons.
First is that a direct investment in the sovereign debt may not be legal due to domicile restrictions
of the country.
One instance would be the local government requiring the purchaser of debt to have a
business office in the country.
Another instance would be tax restrictions or tariffs in countries with NDF currencies.
A fund in USD would have difficulty repatriating the currency if local restrictions or taxes
made it undesirable.
When this occurs, the sell side global bank purchases the debt and structures it into
a derivative note then issued to the client or clients.
The client then owns the issued security which derives its total return from the underlying
instrument.
A CDS, credit default swap, is embedded in the instrument.
It can be thought of as a fully funded total return swap where the underlying asset total
return is exchanged for a funding fee as well as the cost of the issued CLN.
From a market risk perspective owning a CLN is almost identical to owning the local debt.
However downstream, in the back office, difficulties can arise from failure to appropriately control
the risks associated from the lack of data and compatibility of accounting platforms.
The issue stems from the bespoke nature of the CLN in that it is priced in USD but the
underlying asset is denominated in another currency.
Secondly, the sell side may price the CLN based on the issued asset in USD.
This in turn does not appropriately reflect the Yield to Maturity of the underlying asset
as it approaches par value at maturity.
Thirdly, the underlying asset may be inflation linked, or have periodic paydowns that compound
the first and third issues mentioned before.
Notes ^ HK Hong Kong Gov't seeks to help Lehman
minibond investors, International Business Times, 22 September 2008
Under this structure, the coupon or price of the note is linked to the performance of
a reference asset.
It offers borrowers a hedge against credit risk, and gives investors a higher yield on
the note for accepting exposure to a specified credit event.
See also Credit
Credit derivative Credit derivative risks
Credit risk Equity-linked note