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Credit derivatives are grouped into funded and unfunded variants. In an unfunded credit derivative, typified by a credit default swap, the protection seller does not make an upfront payment to the protection buyer. In a funded credit derivative, typified by a credit-linked note (CLN), the investor in the note is the credit-protection seller and is making an upfront payment to the protection buyer when buying the note. Thus, the protection buyer is the issuer of the note. If no credit event occurs during the life of the note, the redemption value of the note is paid to the investor on maturity. If a credit event does occur, then on maturity a value less than par will be paid out to the investor. This value will be reduced by the nominal value of the reference asset to which the CLN is linked. In this article, we explain how CLNs work and discuss some recent applications.
DESCRIPTION OF CLNs
Credit-linked notes exist in a number of forms, but all of them contain a link between the return they pay and the credit-related performance of the underlying asset or pool of assets. A standard CLN is a security, usually issued by an investment-grade entity, which has an interest payment and fixed maturity structure similar to a conventional bond. The performance of the CLN, however, including the maturity value, is linked to the performance of a specified underlying asset or assets, as well as that of the issuing entity. CLNs are usually issued at par. They are often used as a financing vehicle by borrowers in order to hedge against credit risk; CLNs are purchased by investors to enhance the yield received on their holdings. Hence, the issuer of the CLN is the protection buyer and the buyer of the note is the protection seller.
Essentially CLNs are hybrid instruments that combine a pure credit risk exposure with a conventional bond. The CLN pays regular coupons; however, the credit derivative element is usually set to allow the issuer to decrease the principal amount, and/or the coupon interest, if a specified credit event occurs.
ILLUSTRATION OF A CLN
To illustrate a CLN, consider a bank issuer of credit cards that wants to fund its credit card loan portfolio via...