Credit-Linked Notes & Effects on Global Markets

What is a Credit-Linked Note?

A credit-linked note (CLN) is a derivative which offers synthetic exposure on an credit default swap (CDS).  The difference between a CDS and CLN is that the credit-linked note is an on-balance sheet item.  CLNs are primarily used for credit default swaps, but can be used as a hedge for other forms of debt.  A company looking to spread its risk for a specific credit event will look to issue CLNs in order to transfer this exposure to credit investors.  Special Purpose Companies (SPC) or trusts create the CLNs, which start out with a AAA credit rating and then act as a broker between the credit issuer (company) and credit investors.  These notes are offered to investors as both a credit default swap (riskier investment) and the AAA bond at par value.  Credit investors are willing take on this credit risk in hopes of receiving a higher yield on their investments than with typical bonds.  The trust or third party will then sell default protection in retrun for a premium that subsidizes the coupon payments to be made to the holder of the CLN.  Hence the credit investor has exposure to both the CLN and the credit issuer. 

Effects of Credit-Linked Notes on the Global Market

The credit crisis of 2008 has brought a lot of public scrutiny to the credit derivatives market.  Lehman Brothers was one of the companies which received such a public thrashing.  Lehman Brothers had sold billions of dollars worth of credit-linked notes to investors in Hong Kong, packaging them as mini bonds.  These mini bonds were sold as a low risk investment with a third party insurer in the event the bonds were worthless.  Well. once Lehman went under, it left a number of investors with bonds that were not worth the paper they were printed on.  Many investors in Hong Kong are outraged because the CLNs were sold by sales people who emphasized that the CDS were packaged with a "safe" bond with a AAA credit rating.

Credit-Linked Notes Chart Example

Below is a chart of example of relationship between the trusts, credit investor and the credit issuer.
Credit-Linked Note
Tim Ord
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