Credit Linked Note

In trying to understand credit linked notes, the first thing to understand that the concept itself is a bit complicated. Actually, a note is similar to a bond as it receives regular payments that are generally paid twice each year. On the other hand, bonds aren’t generally customized whereas a note can be. One of the major ‘customizations’ in a credit linked note (CLN) is that the note carries with it something known as a credit default swap (CDS). In effect, this is like an insurance policy on the note that transfers some of the risk to the buyers in return for potentially higher yields. This is where it gets complicated so it is best to take it step by step to see how all the pieces fit into the puzzle.

CDL as Insurance for the Creditor
The process begins with the company that issues the note. This company sells the credit default swap, CDS, to a bank or other financial institution in return for an annual fee paid to the issuing company. This fee, paid by the bank, is then transferred to investors as higher returns. From the opposite perspective, that of the bank/creditor, the creditor would have the ability to transfer the default risk back to the issuing company IF the company is unable to pay the investors. Although this is perhaps a bit difficult to understand, the bottom line is that the bank is given a type of ‘insurance’ against the risk of default because they can transfer that risk back to the company if needed. However, the investors also have to potential to realize higher returns for their investment because the issuing company has annual payments from the bank to disperse among investors.

Are Investors Protected Against Loss?
This is where investors need to be careful. It appears as though the buyer/investor is the one protected in all of this because the default risk is transferred back and forth between the issuing company and the bank/financial institution/creditor. This isn’t the case at all. Now it’s time to take a look at it from a different perspective. As with any investment, it should be recognized that the only way to make money on that investment is when the underlying asset (in this case the issuing company) does well. If the issuing company indeed does well then investors (buyers of the CLN) will yield higher returns. That makes sense, right? Basic economics 101. But what happens if the underlying asset/issuing company defaults? Who loses out here?

The Buyer/Investor Carries the Bulk of Risk
The bank certainly doesn’t lose out because at that point they simply transfer the risk back to the company. Now then, the company is already doing poorly as evidenced by the fact that they are unable to pay their investors. So what happens to the investor/buyer of the note? Bear in mind that the buyer has sold the risk to the bank/creditor to take on that risk. The bank has already transferred the risk back to the issuer. This is where the confusion rests. Where is the buyer left in all of this? Unfortunately, this leaves the buyer/investor in a bit of a bind. That buyer will probably only receive a mere fraction of the face value of the note since the underlying asset has not done well or may even be bankrupt at the time the note matures.

All of this is not to say that credit linked notes are not a good or sound investment. Actually, they could just be. The key is to buy credit linked notes based on expert analysis of the market so that the risk of default is minimized based on market projections for the underlying asset. A credit linked note is advantageous to the investor if the company does well because higher returns will be realised. However, just as in any other investment, if the company does not do well, the investor loses. The major benefit in credit linked notes is that they have the potential to provide higher returns. The risk is the same as in most other investment schemes.

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