Credit-linked notes (CLNs) are typically issued by dealers or by special-purpose companies (or special-purpose vehicles, SPVs) domiciled in an offshore location. Some dealers have a medium term note (MTN) issuance programme under which they can issue notes in their name, which are linked to reference entities to which investors want to take risk.
For example, an investor might want to take $10 million of exposure to Hilton Hotels in a maturity or currency for which there are no outstanding Hilton bonds. A dealer with an MTN programme could issue a $10 million note in its own name, with Hilton being the primary credit risk of the instrument. The investor would pay the dealer $10 million on the trade date to buy the note, whose proceeds the dealer puts into its own deposit. The dealer issues a note which embeds a credit default swap in which the dealer buys $10 million of Hilton protection from the investor. The note coupon would consist of the interest earned from the deposit (typically Libor) plus the spread of the credit default swap, and would be paid to the investor quarterly.
If there is no default, the credit default swap and deposit terminate on the maturity of the note, and the proceeds from the redemption of the deposit are paid back to the investor. If Hilton experiences a credit event, the deposit is unwound and its proceeds used to pay the dealer the par amount. The dealer then pays the investor the recovery amount in the case of a cash settled CLN or delivers deliverable obligations in the case of a physically settled CLN. Credit-linked notes are also often issued by SPVs. SPVs are set up by dealers to issue numerous different credit-linked notes. However, the notes are documented so that each investor’s risk exposure is completely segregated.
Applying the example above to an SPV-issued CLN, the dealer arranges for its Cayman Island’s vehicle XYZ Finance Limited, to issue $10 million of notes. The investor buys the note from the SPV and the proceeds are invested in low-risk collateral such as triple A rated Rabobank bonds. (Sometimes, the collateral takes the form of a repo agreement with the investment bank.)
XYZ Finance Limited then sells protection on a $10 million Hilton Hotels credit default swap to the dealer. The premium from the credit default swap along with the coupons from the collateral are paid to the investor quarterly. If there is no default, the credit default swap terminates and the collateral redeems on maturity, and the collateral redemption proceeds are paid back to the investor. If there is a credit event, the collateral is sold and its proceeds used to pay the dealer the par amount. The dealer either pays the investor the recovery amount or delivers deliverable obligations to the investor.
From a protection seller’s point of view, investing in a credit-linked note is like buying a bond issued by the reference entity. The investor pays the notional amount of the trade upfront, receives a regular coupon payment and receives principal back when the bond matures. In the event of default, the investor receives the recovery rate of the reference entity’s debt. Investors buy credit-linked notes for a variety of reasons. Credit-linked notes are investments customised to their maturity, currency and coupon requirements, and could match their liabilities far more closely than bonds available in the market. Some investors are not allowed to trade derivatives, so may not be able to sell protection on credit default swaps, but can buy credit-linked notes which are securities. Other investors may be able to sell protection, but prefer to buy credit-linked notes since they have cash to invest.