Credit Derivatives: Trading, Investing and Risk Management, Second Edition

13

Credit-Linked Notes

13.1 CLN SET-UP; COUNTERPARTY OR COLLATERAL RISK

In a credit-linked note (CLN) the buyer of protection (seller of the note) transfers credit risk to an investor via an intermediate bond-issuing entity. This intermediary can be the buyer’s own treasury or a third party’s treasury using a limited recourse note programme, or via a special purpose vehicle (SPV).

The former route is conceptually simpler, and is cheaper to use once the note programme is set up. The purpose of the limited recourse note programme - a set of legal documentation and an issuing process - is to make it clear to investors and others that the failure of the note to provide the full cashflows (for example, on a credit event of the reference entity) does not constitute a default by the issuing bank.

It is helpful to think in terms of a simple CLN, where the embedded risk is exposure to (say) France Telecom. The note may mirror CDS terms and conditions - it may have a 5-year life, paying LIBOR plus (say) 250 bp (or it may be a fixed coupon note), but it will terminate early if France Telecom suffers a (CDS) credit event. In that case coupons on the note cease, and the investor receives the notional on the note less an amount determined by the issuing bank - CLNs are typically cash settled. The terms embedded in the note may (and often do) differ in detail from those of a CDS. For example, a specific bond may be referenced for the purposes of calculating the cash amount; accrued interest ...