Finance

HOW ASSET-BACKED CREDIT-LINKED NOTES WORKS

HOW DOES ASSET-BACKED CREDIT-LINKED NOTES (CLN) WORKS

INTRODUCTION 

  • Credit derivatives are categorized into funded and unfunded.
  • In an unfunded credit derivative, typified by a credit default swap, the protection vendor will not make an advance charge to the protection buyer and the vendor will only reimburse if the loss incident occurs.
  • In a funded credit derivative, typified by a credit-linked note (CLN), the investor in the note is the credit protection seller and makes an initial charge to the protection buyer while purchasing a note. So the buyer of security is the issuer of the note.
  • CLN is a note/bond with a CDS attached where the protection seller has prepaid the damage in the form of a note/bond to the protection buyer.

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In simple, CLN is equivalent (from the issuer’s perspective) to

 

 

ANALYSIS OF ASSET-BACKED CREDIT-LINKED NOTES:

  • Credit-linked notes exist in a number of forms, but all provide a correlation between the return they are paying and the underlying asset’s credit-related results.
  • A typical CLN is a security issued generally by an investment-grade issuer with an interest payment and a fixed maturity duration close to that of a vanilla bond.
  • However, the performance of the CLN, including its maturity value, is correlated with the performance of specified underlying asset (reference asset)  or interest as well as that of the issuing entity(reference entity).
  • They can be linked to a particular corporate loan or security through a portfolio of securities, sovereign debt instruments, or indices. Holders of CLNs have exposure to but do not own, the reference credits.
  • In addition, holders of CLN buy credit risk (or sell credit protection) from counterparty that sells credit risk (or buys credit protection) on the reference credits.
  • CLNs are usually issued at par. They are mostly used by borrowers as borrowing tool to protect against credit risk; investors buy CLNs to maximize the yield they earn on their investments.
    Hence, the issuer of the CLN is the protection buyer and the buyer of the note is the protection seller.
Like the CDS, there are variety of credit incidents that can be used in CLN terminology: Bankruptcy, Restructuring, or Failure to Pay.

CLNs are usually provided by an SPV or trust and would enter into a  credit default swap with a valued counterparty in association with the issuance of the CLNs. The prevailing credit risk borne by CLN investors is the reference credit and the swap counterparty.

 STRUCTURE OF A CREDIT-LINKED NOTE TRANSACTION 

Suppose a bank issues CLN to investors

  1. Credit-linked note on the issue
  • Bank issues CLN
  • Investors pay cash to buy the note
  • Bank makes daily coupon payment before the note expires

HOW ASSET-BACKED CREDIT-LINKED NOTES WORKS

 

  1. When there’s no credit event at maturity
  • The investor receives principal repayment

HOW ASSET-BACKED CREDIT-LINKED NOTES WORKS

  1. Credit Event happens
  • As in credit default swaps, CLNs can be either cash-settled or settled physically.
  • Under cash settlement, upon the occurrence of a credit event, the note is terminated. The protection buyer will pay to the protection seller the default value, or the recovery value (RR), of the reference name. This is the equivalent of payout [100 – RR] under CDS contract.

 

  • Under the physical settlement, upon the occurrence of a credit event, the note is terminated. The protection buyer will deliver a deliverable bond—out of a deliverable basket of reference entity bonds—to the protection seller. The protection seller, of course, retains the original CLN bond, issued by the reference entity.

HOW ASSET-BACKED CREDIT-LINKED NOTES WORKS

 

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Below is the snapshot of the Credit-linked note issued by BNP Paribus (Extract from a CLN factsheet – BNP Paribus)

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Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.

Related:

Functioning of Credit Default Swaps

How is Credit Default Swap (CDS) settled?

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