Credit-linked note (CLNs)

A security with an embedded credit default swap allowing an issuer to transfer a specific credit risk to credit investors.

The main advantages at a glance:

Diversification: CLNs enable you to access and take credit exposure to a wide range of "reference entities" without actually having to hold bonds issued directly by such reference entities.
Tailored bond: CLNs enable you to tailor the key components of "your" CLN: reference entity/ entities, leverage, coupon, maturity, price, etc.
Rating and Listing: CLNs may be assigned ratings by the rating agencies and may be listed on a variety of stock exchanges.
Spread pickup over cash: You may get a higher yield than a direct holding of a bond issued by the same reference entity with an equivalent maturity.
Leverage: You can add different degrees of leverage to a basket of reference entities, by applying the Nth-to-Default structure.

Under the structure, the coupon or price of a note is linked to performance of a referenced asset. It offers borrowers a hedge on credit risk, and gives investors a higher yield on a note for accepting exposure to a specified credit event.

In general, a credit-linked note is a type of financial derivatives under which payment is linked to the creditworthiness of a specific company. An investment bank will approach investors who are interested in exposure to the bonds of a given company. The investment bank offers to sell them notes yielding significantly more than the corporate bonds themselves – say, 9% for the credit -lined notes versus 7% for the bonds. The credit-linked notes are backed by collateral that is highly rated, such as Treasury securities. If all goes well, the buyer of the credit-linked notes mature. The catch: If the company whose creditworthiness is at stake defaults, investors don’t get the Treasurys. Instead, they get the real bonds of the underlying company – whose value has plummeted.

The Italian dairy products giant, Parmalat, notoriously dressed up accountancy books by creating a credit linked note for itself, betting on its own credit worthiness. CLNs themselves are typically backed on very highly rated collateral, such as USA Treasury securities. Parmalat’s £21.5 million credit-linked notes were issued by Sires Star, a Grand Cayman special purpose vehicle on Sept. 1, 1999, according to the preliminary term sheet, and offered a coupon of 9.375%. Merrill Lynch International was the counterparty, the document states. People familiar with the deal say the final document wasn’t materially different in these matters.

CLNs are created through Special Purpose Company (SPC), or trust, which is collateralized with AAA rated securities. Investors buy securities from a trust paying a fixed or floating coupon during the life of a note. At maturity, investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to recovery rate. The trust enters into default swap with a deal arranger. In case of default, the trust pays a dealer par minus recovery rate in exchange for an annual fee passed on to investors in form of a higher yield on notes.

Credit-linked notes became increasingly popular from 1997 as banks tried to reduce their exposure to risk of default in loans to emerging markets or companies. They also help a bank to limit its regulatory capital requirements, as credit-linked notes do not represent claims against the underlying borrower. Instead, a bank manufactures the credit-linked note by splitting up the underlying Brady bonds (or other assets) into segments with differing risks and returns.

The Ecuadorian 1999 default rose questions for the whole credit linked note market. The decision by the Ecuadorian government to default on two of its three types of Brady bond in September led several banks to cancel credit-linked notes based on Ecuador’s Bradies. Although the price of the PDIs fell from 45% of face value in May to 18% by early October, Ecuador continued to pay interest on the bonds. CSFB insisted that its credit-linked notes documentation specifies it has the right to call the notes if the price of the underlying PDIs falls below a certain level. Indeed, the prospectus states, in bold type on the front page, the amount payable following a credit event or a securities redemption may be reduced to zero by the termination value of the reference swap transaction. Ecuador’s decision not to pay the $95.3 million interest payment due on par and discount bonds cost the government its economy minister, Guillermo Lasso, who wanted to make the interest payment. He was opposed by the finance minister, Rafael Arízaga.

A Credit-Linked Note (CLN) allows you to obtain credit exposure to a wide variety of underlying entities in order to enhance the return on the fixed income part of your investment portfolio.

The characteristics of a Credit-Linked Note resemble those of a regular corporate bond, both in terms of cash flow and associated credit risk. The issuer of a CLN issues a note that is linked to the credit of one or more "reference entities". The term "credit" refers to the possibility of a loss due to the failure by an entity to meet its contractual obligations of timely interest-payment and repayment of notional. The holder of a CLN has "credit" exposure to the issuer of the notes as well as to the reference entity or entities as defined in the terms and conditions of the CLN. By purchasing a CLN you are effectively selling credit protection in relation to the reference entity or entities. In return you receive a coupon representing the premium paid by the buyer of credit protection. While a bond-investor bears the credit risk of the issuer of the debt instrument he physically holds, a Credit-Linked Note (CLN) gives you synthetic exposure to the occurrence of predetermined credit events* in relation to underlying entities. If no credit event occurs during the term of the CLN, it is redeemed on its maturity date at its nominal amount. CLNs may be Single Name CLNs, Basket CLNs or Nth-to-Default CLNs.

Structure

Single Name CLN

A Single Name CLN is the most straightforward CLN as it references only one reference entity. If no credit event occurs during the lifetime of the CLN, you will receive a coupon (established upon the issue date of the CLN). At maturity of the CLN, you are paid the principal. If a credit event occurs prior to the maturity date of the CLN, no further coupon payments will be paid and the Single Name CLN will be redeemed by payment to you of an amount equal to the market value of obligations issued by the reference entity (cash redemption).

Basket Credit Linked Note (Basket CLN)

A basket credit linked note (Basket CLN) is a note, which references a basket of reference entities. Investors will receive a coupon (established upon the issue date of the CLN) until the earlier of the maturity date of the CLN or the date on which credit events have occurred in respect of every reference entity. If a credit event occurs the nominal amount of the CLN will be reduced by the same proportion as the relevant reference entity bears to the basket and the investor will be paid an amount equal to the recovery value of outstanding obligations issued by the relevant reference entity (cash redemption). Thereafter, as the nominal amount of the CLN has been reduced then coupon payments will be reduced proportionally and the coupon rate may be reset.

As the Basket CLN is not terminated following a credit event, the remaining nominal capital continues to be exposed to potential credit events throughout a remaining term. With a Basket CLN, the loss potential per reference entity is limited to proportional weighting of each reference entity within the basket. In other words, if there are five equally weighted entities in the Basket CLN, an investor can lose a maximum of 20% (minus recovery value) of the nominal capital when each credit event occurs.

Nth-to-Default Credit Linked Note (NTD CLN)

A Nth-to-Default Note (NTD CLN) is a note, referencing a basket of reference entities. The difference between a Basket CLN and a NTD CLN is upon occurrence of a predetermined number of credit events in relation to reference entities the entire NTD CLN terminates whereas a Basket CLN continues with reduced nominal amount . A NTD CLN would terminate after n reference entities suffered a credit event, ie a 1st-to-default after one reference entity, a 2nd-to-default after two reference entities suffered a credit event, etc.

In contrast to a Basket CLN, with a NTD CLN the loss potential per reference entity is not limited to the proportional weighting of each reference entity within the basket but instead to the entire nominal amount of the NTD CLN. When a credit event occurs in respect to the Nth reference entity in the basket, no further coupon payments will be paid to the investor and the NTD CLN will be redeemed by payment to the investor of an amount equal to the market value of obligations issued by the relevant reference entity (cash redemption). In other words, in a NTD CLN, the investor could lose a maximum of 100% (and not just 20%) of the nominal amount when one reference entity experiences a credit event even if there are five entities in the NTD CLN.

In 2003 JPMorgan and Morgan Stanley brought in a $400 million Credit-Linked Note Issue via a Jersey special purpose vehicle. Credit-Linked Notes due 2008. The issue became public on 9 October 2003.

The ISE reported on a ARLO IV LIMITED EUR 10,000,000 Secured Limited Recourse Credit-Linked Notes due 2013 Series 2006

The ISE website notes a €4,000,000,000 CREDIT LINKED NOTE PROGRAMME by DRESDNER BANK AKTIENGESELLSCHAFT in 2006.

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