AN OVERVIEW OF CREDIT LINKED NOTE

Submitted by

Manit Singh Rakhroy Roll No. 02 PGDM-FM (2010 -12)

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STRUCTURED PRODUCT CREDIT LINKED NOTE

A structured product is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps. A feature of some structured products is a "principal guarantee" function, which offers protection of principal if held to maturity. For example, an investor invests 100 dollars, the issuer simply invests in a risk free bond that has sufficient interest to grow to 100 after the five-year period. This bond might cost 80 dollars today and after five years it will grow to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy is. Theoretically, investors can just do it on their own, but the costs and transaction volume requirements of many options and swaps are beyond the affordability of many individual investors. Structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend. Structured products are usually issued by investment banks or affiliates thereof. They have a fixed maturity, and have two components: a note and a derivative. The derivative component is often an option. The note provides for periodic interest payments to the investor at a predetermined rate, and the derivative component provides for the payment at maturity. Some products use the derivative component as a put option written by the investor that gives the buyer of the put option the right to sell to the investor the security or securities at a predetermined price. Other products use the derivative component to provide for a call option written by the investor that gives the buyer of the call option the right to buy the security or securities from the investor at a predetermined price. These products are created through the process of financial engineering, i.e., by combining underlyings like shares, bonds, indices or commodities with derivatives. The value of derivative securities, such as options, forwards and swaps is determined by (respectively, derives from) the prices of the underlying securities.

Various types of structured products have been engineered over the period of time: Some of them are as follows: Forex and commodity linked notes Equity linked notes Market linked notes Credit Default Swaps (CDS) Credit linked notes

Major focus of this paper will be on credit linked notes and issues related with it.
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CREDIT LINKED NOTES

A credit-linked note, also known as a CLN, is a note with a credit default swap attached. The issuing company sells the credit default swap to the bank and receives an annual fee, which is then passed on to the investors of the note in the form of higher return. The credit default swap also allows the creditor or bank to transfer the risk of default on the note back to the company if the company cannot pay its investors. So the credit-linked note structure provides banks with insurance against default risk, and companies, or issuers, with the ability to pay investors a higher rate of return. First of all we should discuss credit default swap (CDS) as it forms an important part of the credit linked note. A credit default swap is a contract which allows the buyer to sell the risk associated with default in exchange for a fee which is paid annually to the seller; this is much like the premium paid on car insurance. If something happens to the car, the insurance company pays for the expenses related to the accident. In order to create a credit-linked note, the issuer sells a CDS to the bank that is underwriting or backing the note. Top investment banks command higher amounts of funding for note and bond offerings. These top investment banks, however, don't like risk, so they buy a CDS as a form of insurance against default on the note. The structure of the credit-linked note is tricky. A special purpose entity or trust is created which is affiliated with the issuing company. The special purpose entity purchases AAA-rated investment securities these securities are considered to be risk-free securities. At the same time, the special purpose entity sells a CDS to the bank which is underwriting the note. The credit-linked note is linked to both the AAA-rated investment securities and the credit of the company which created the special purpose entity. If both the AAA-rated paper and the company perform well, the investor receives the stated value of the note or par value at maturity. If either defaults, however, the investor gets pennies on the dollar, which is also known as the recovery value. In case of company default, the company must pay the investment bank the difference between par value and the recovery value, which is tricky if the company can't even pay its investors. To accomplish the required payout, the company sells AAA-rated investment securities which are not linked to the defaulted company. These are the securities which are embedded in the credit-linked note through the CDS. In this way, the bank is insured against major losses regardless of the outcome.

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EMERGING MARKET CREDIT LINKED NOTES The emerging market credit linked note, also sometimes called a clean, are traded by buy side clients to gain access to local debt markets for several reasons. First is that a direct investment in the sovereign debt may not be legal due to domicile restrictions of the country. One instance would be the local government requiring the purchaser of debt to have a business office in the country. Another instance would be tax restrictions or tariffs in countries with NDF currencies. A fund in USD would have difficulty repatriating the currency if local restrictions or taxes made it undesirable. When this occurs, the sell side global bank purchases the debt and structures it into a derivative note then issued to the client or clients. The client then owns the issued security which derives its total return from the underlying instrument. A CDS, credit default swap, is embedded in the instrument. It can be thought of as a fully funded total return swap where the underlying asset total return is exchanged for a funding fee as well as the cost of the issued CLN. From a market risk perspective owning a CLN is almost identical to owning the local debt. However downstream, in the back office, difficulties can arise from failure to appropriately control the risks associated from the lack of data and compatibility of accounting platforms. The issue stems from the bespoke nature of the CLN in that it is priced in USD but the underlying asset is denominated in another currency. Secondly, the sell side may price the CLN based on the issued asset in USD. This in turn does not appropriately reflect the Yield to Maturity of the underlying asset as it approaches par value at maturity. Thirdly, the underlying asset may be inflation linked, or have periodic paydowns that compound the first and third issues mentioned before.

MECHANISM OF CREDIT LINKED NOTES

A CLN is a structured note with an embedded default swap, in which Issuer/ SPV issues notes to investors which are backed by the reference assets, and receives the proceeds. Issuer/ SPV sells protection on the reference asset in a default swap with a third party (bank), and receives the swap rate. Issuer/ SPV pays an enhanced coupon to note investors.

Following diagram clearly shows the payment process of Credit Linked Notes:

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PAYOFFS TO CREDIT LINKED NOTES INVESTORS The credit Linked Note terminates at default of the reference asset or the maturity whichever is first. If there is no default, the default swap terminates and the note investor receives the full note principal. In case of default, the SPV pays the default losses to the default swap protection buyer. Credit Linked Note investors do not receive the full principal repayment, but lose an amount equal to the default losses. A (less-risky) principal-protected Credit Linked Note is not terminated at default, but interest payment to the note ceases. At maturity, the full principal is returned to the note investor.

CREDIT LINKED NOTES SPREAD Credit Linked Note investors bear the potential losses due to default of the reference asset. In return, they pick up some yield. In essence, the position of the note investors is if they had sold default protection on the reference asset via a Default Swap to the Credit Linked Note issuer/SPV. Thus, the spread picked up by the Credit Linked Note investor must roughly equal the Default Swap rate paid by the SPV. In practice, the Credit Linked Note spread is somewhat higher than the DS spread, since the accrued swap rate is normally not paid in a Credit Linked Note.

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PROTECTION BUYER IN CREDIT LINKED NOTE Usually, the SPV puts the proceeds of the note issuance in collateral. If the reference entity defaults, the SPV liquidates the collateral and simply pays less principal back to the note investors. This spared amount is directly passed through to the protection buyer (a bank) in the DS. Since the SPV has a very high rating (usually AAA), the bank is not exposed to a significant counterparty default risk in the DS (it were exposed if it had contracted the DS with the investors directly). WHY ARE CREDIT LINKED NOTES ATTRACTIVE? Provides a funded credit derivative investment opportunity which is used by real-money Default Swap investors such as mutual funds, investment departments of insurance companies, pension plans, which are not authorized to invest directly into credit derivatives Provides a yield pickup to other securities issued by the reference entity. Provides customized maturity structures and credit features that are not otherwise available in the cash market. If used by banks to lay off loan credit risks, a CLN provides access to funded credit opportunities that are not otherwise available.

WHY INVESTORS BUY CREDIT LINKED NOTES? 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.

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WHY ISSUERS SELL CREDIT LINKED NOTES? 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).

AN EXAMPLE OF CREDIT LINKED NOTE TRANSACTION CLNs are issued by third parties and give credit exposure to a specified company (known as the reference entity). In exchange for taking the credit risk on the reference entity, the investor receives regular coupon payments. By way of an example, we will look at a company B (AAA/Aaa) CLN issued by company X in Euro. The standard maturity for such a transaction is 5 years and the investor can choose to receive either a fixed or floating rate coupon. 5 year credit linked note by company B Trade Date Issue Date Maturity Date Reference Entity Coupon Government bonds Coupon Issue Price 17 Dec 2010 17 Dec 2010 16 Dec 2015 Company B 4.48% 3.58% Rs. 100.00

The CLN above is created as a unique security by company X. As with a bond, the investor will invest principal on the issue date and in exchange will receive the fixed annual coupon of 4.48%. If company B does not experience a credit event during the life of the note, the investor will receive their final coupon payment and principal back in full at maturity. If company B experiences a credit event, such as bankruptcy, the CLN will cease to exist and the issuer (company X) will deliver to the investor the bonds of GE. The investor then seeks to recover their funds from company B along with other creditors of the company. Alternatively, the structure may allow for determination of the bond value in accordance with generally accepted market practices.

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CREDIT LINKED NOTES VERSUS EQUIVALENT BONDS Taking the above example, we can compare the return on the CLN to the return on a benchmark 5 year company X bond. The company X 5.125% June 2007 bond has a current spread over government bonds of 46 basis points. This spread on the above CLN example is 90 basis points. The reason for this pickup is the supply and demand of credit derivatives versus bonds. A greater proportion of the market will use credit derivatives to hedge or reduce exposure to a corporate rather than sell the underlying bonds. As such, we generally experience a widening of CLN spreads over their equivalent bonds when hedging activity takes place. The example above is a CLN in its simplest form. It is important to note that the reference entity can be almost any investment grade corporate or government. The next step is to combine a group of credit risks into one note. This is often referred to as a linear basket and has the same risk profile as buying CLNs on each of the underlying reference entities. Hence, we can conclude by saying that credit linked notes can be used to earn higher profits and reduce risk. However, it has various risks imbedded in it and the investors should take into account the risks involved in the investment in credit linked notes before investing.

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