Credit Linked Notes

What is a Credit Linked Note, (CLN)?

A CLN is normally a bond that has been issued using a medium term note programme. It is the direct obligation of the issuer but it contains additional credit risks for the buyer.

The principal repayment is linked not only to creditworthiness of the issuer but also a third party known as the reference entity.

Provided the reference entity experiences no credit event during the life of the CLN the principal will be repaid to the investor on maturity.

During the life of the note the investor will also have received regular interest payments, (coupons).

Should the reference entity experience a credit event this triggers redemption of the CLN. But instead of receiving the principal amount originally invested, the investor receives a bond issued by the reference entity. The value of the bond will be worth less than the principal invested.

How does it work?

Let's suppose your bank issues medium term notes and wants to structure a CLN. How is it put together? Typically the bank would select a reference entity and would then sell protection using a credit default swap, (CDS), on that selected reference entity. Selling protection would mean the bank received a regular fixed payment from the CDS counterparty.

The bank now issues the CLN. The CLN would be for the same principal amount and maturity as the CDS. The final terms of the CLN would mirror the terms in the CDS transaction.

The CLN investor would pay cash to the bank to buy the note. The bank would pay the investor regular interest until the maturity of the note, (see diagram 1).

Provided there is no credit event by the reference entity the investor receives back the principal investment on the maturity of the note, (see diagram 2).

What happens if the reference entity experiences a credit event? The investor will experience a credit loss, this is what happens:

The CDS on which the bank sold protection is triggered. The bank pays to the CDS counterparty the principal amount of the CDS in cash. The bank receives in return a deliverable instrument normally a bond that was issued by the reference entity that is now in default.
The CLN is also triggered. The investor does not get his principal returned, instead the bank on-delivers the bond to the CLN buyer, (see diagram 3).

The investor will have experienced a loss as a result of the credit event because the delivered bond will be worth less than the original sum invested. The scale of the loss incurred will depend on the market value of the delivered bond.

Why investors buy CLNs

The investor has the credit risk on the reference entity as well as the CLN issuer and therefore obtains a higher return on the CLN than would have been achieved on a normal medium term note.

This means that different CLNs can be issued that exactly fit the investor's criteria including return, rating, maturity and amount. It can also mean that investors who are restricted from using credit derivatives because of operational, legal or regulatory constraints can still create the investments they want.

Furthermore some investors are "real" investors - they have cash and need to use it. CLNs are cash based investments and meet these investor's requirements.

CLNs are also relatively simple to book from the buyer's perspective they are often regarded as cash instruments rather than derivatives. This means the investor does not need to enter into an ISDA master agreement. The final terms that accompany the CLN will contain the detailed information concerning the workings of the transaction.

Why issuers sell CLNs

The issuer receives cash from the sale of the CLN. This has two advantages.

First it can mean that the cost of funding for the issuer can be at or below the target cost of funding.

Second because the issuer has cash it means that the embedded CDS is effectively 100% cash collateralised, (remember that the issuer is selling protection to the market place but buying protection from the investor). If there is a credit event the issuer is in control of the cash and is not dependent on the performance of the investor, (as it would normally be the case with a CDS).

Does this mean that everyone wins?

Not necessarily. It depends on whether the note is issued at "fair value". This is a key point. The CLN buyer is a credit protection seller.

If the additional yield on the CLN does not fully reflect the additional credit risk being taken the investor is sharing some of the value.

This will either go to lowering the issuer's funding cost or in structuring fees. All is negotiable, caveat emptor.

Diagram 1 - Issuance

Bank sells credit protection
Bank issues CLN
Investor buys note and receives a regular coupon

Diagram 2 - Maturity & no credit event

Investor receives principal repayment
CDS trade matures

Diagram 3 - Credit event

Bank pays par, (100%) to CDS counterparty
Bank receives deliverable bond issued by reference entity
Investor receives deliverable bond instead of cash
Net effect: investor experiences a credit loss

First Published by Barbican Consulting Limited 2006