Credit-linked note
Encyclopedia
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.
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.
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
. It is structured as a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
with an embedded credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
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
Trust company
A trust company is a corporation, especially a commercial bank, organized to perform the fiduciary of trusts and agencies. It is normally owned by one of three types of structures: an independent partnership, a bank, or a law firm, each of which specializes in being a trustee of various kinds of...
, designed to offer investors par value
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
at maturity unless the referenced entity defaults
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. 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
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
, such as U.S. Treasury securities
Treasury security
A United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States federal government, and they are often referred to simply as Treasuries...
.
The Italian dairy products giant, Parmalat
Parmalat
Parmalat SpA is a multinational Italian dairy and food corporation. Having become the leading global company in the production of ultra high temperature milk, the company collapsed in 2003 with a €14 billion hole in its accounts in what remains Europe's biggest bankruptcy...
, 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
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
, 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.
Example
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.
See also
- CreditCredit (finance)Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
- Credit DerivativeCredit derivativeIn finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
- Credit derivative risks
- Default RiskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
- Equity-Linked Note (ELN)