Understanding Credit-Linked Notes

[Hend Abuenein]

Hi David,

Would you please give an example to clarify what CLNs are? But please give parties of example names, all examples I found called them buyer, issuer and seller. For this kind of credit derivatives only I confuse them together.
Also, I don't understand in CLNs whose default risk is being mitigated, and who is bearing that risk.

Thank you

 

[Hend Abuenein]

Actually there's a lot more that I don't understand about it but I think you'll explain all in a good example..like you always do

Thanks

 

[Hend Abuenein]

Hi David,
Would you please let me know the answer to this.
A brief example will do.
Thanks.

 

[Leli]

Hi hend,

here my simplified notes (compilation of davids + core reading). Maybe it will help you.


Credit linked note (CLN)
Funded equivalent of a CDS
Credit protection seller had prepaid the loss in the form of a bond, issued by protection buyer, whose cash flows are inversely related to prescribed losses on the reference portfolio. Interest rate is above-market.
·If no event : issuer repays investor scheduled principal + interest (no need for protection any more)
·If credit event : issuer can withhold interest and if necessary part of principal

From protection buyer : equivalent to issue normal bond + buy credit protection
(Par value of note = max payout on the CDS)
From protection seller : knowing max amount to pay BUT bears credit risk of the issuer

CDS : unfunded // exposes protection buyer to credit risk
CLN : funded // exposes protection seller to credit risk

adding : protection seller is the investor (pay PAR to issuer and then (maybe) get back money (interest + principal))

 

[Hend Abuenein]

Thanks Leli for helping explain, much appreciated

So the credit risk of a CDS is born by buyer (that seller fails to payout in case of event happening), where as credit risk in CLN is born by seller and is defined as failure of buyer/issuer to return principal in surplus of payout agreed (in case of event or maturity)+failure to pay scheduled interest.
Am I right?

 

[Leli]

Yes i think it's that, but i'm just a little Part II candidate Maybe David should confirm too.
Just be careful "buyer of protection - issuer of note", or buyer of note - seller of protection
Leli

 

[ChadWOB]

CLN are def a tough subject, one in which I don't fully understand either. For the CDS, there are a few layers of credit risk. The CDS seller(insurer) has credit risk that the underlying will trigger a credit event. The CDS buyer(insured) has credit risk that the seller(insurer) will be able to make the payout if of a credit event occurs (ignoring fact you don't need an insurable interest to enter into the CDS!)

For the CLN - the issuer of the CLN (which originally held the risky credits) is transferring their credit risk into the CLN. Investors/buyers of the CLN assume the credit risk away for the CLN and issuer. The buyers are compensated for assuming this credit risk via a higher coupon than they might get elsewhere.

Think this is correct, hoping not to see much 'testability' on the CLN though. I haven't seen many practice questions on them at least.

 

[Hend Abuenein]

Thanks Leli & ChadWob,
I formed a basic picture here. Let's hope it won't be tested in depth.

 

[David Harper CFA FRM]

Hi Hend,

Sorry I'm late to this thread. I think Leli's summary is excellent.

In case it helps, below is diagram from our notes/video, which is just stolen from assigned Culp (although I attached, below the Culp image, the CLN diagrams we used prior to Culp, based on Meissner). Key points:

• CLN ~= funded CDS; i.e., in both cases, "investors" sell credit protection on a reference. But CDS is unfunded (earning yield purely for default/deterioration risk), whereas CLN is funded with investor principal (earning yield for default/deterioration risk + financing/use of funds).
• CLN "is economically equivalent from the issuer's perspective to issuing a normal note plus buying credit protection from the bond investor through a CDS" (Culp)
• CLN issuer (aka, protection buyer) = short bond + long CDS; and
  CLN investor (aka, CLN buyer) = long bond + short CDS.
• Risk transfer (key difference): unfunded CDS buyer is exposed to counterparty risk and associated wrong-way risk (adverse correlation between reference and counterparty).
  However, the CLN is FUNDED so the issuer/protection buyer has virtually no counterparty risk. Instead, the CLN buyer has the counterparty risk! (i.e., like any bond buyer, issuer can default on P&I).
  So, FUNDING is the big difference: the counterparty risk switches from protection buyer to protection seller (CLN investor/CLN buyer) who ought to be compensated with additional premium (versus otherwise equivalent CDS) due to fact that funded principal at risk.
• Terminology-wise, you can see it looks to be: protection buyer/CLN issuer versus CLN buyer/CLN investor.
  As i *think* the CLN would be a security, as opposed to CDS derivative, it makes sense to me that CLN investor is a "buyer" not merely a "protection seller" because the CLN investor is purchasing issued securities. (I *think* we have a security/derivative distinction due to the funding, but not 100% sure about that).

 

[Hend Abuenein]

Hi David,

As i *think* the CLN would be a security, as opposed to CDS derivative, it makes sense to me that CLN investor is a "buyer" not merely a "protection seller" because the CLN investor is purchasing issued securities. (I *think* we have a security/derivative distinction due to the funding, but not 100% sure about that)

This is new to me about CLNs.
Your diagram is easier to understand.


Thanks

 

[cqbzxk]

why the protection buyer = CLN issuer ? are they same entity? I thought CLN issuer was protection seller sell CDS to protection buyer, then give protection buyers' CDS premium to CLN investor + riskless coupon = enchanced coupon, is this right?
or I have to understand another way, that CLN issuer transfer CDS risk to CLN buyer, then CLN issuer can be interpreted as protection buyer. CLN buyer = protection seller

 

[Jeffy14]

Hello David,

I have a question regarding the issuer of the CLN. Let's say it's a bank that's selling a product (the CLN).
The bank issues Notes to the CLN investor (the protection seller).
The bank also receives the cash from the investor but also sells a CDS to finance the payment of the CLN coupon to the investor.
Now, the Bank has the cash from the investment. What does the bank do with this cash? Do they buy safe Bonds like treasuries to pay the CLN investor? Do they invest it in the same bond the CLN is based on?
The bank then uses the coupon it receive from the bond + the sell of the CDS to pay the extra coupon to the CLN investor?
So we have:
Coupon from the bond (what kind of bond?) + Coupon from CDS sold = Coupon paid to CLN buyer
Is this right?

The point of a CLN is also to pay a superior coupon to the investor, so how does the Bank makes up for it?
And where does the bank makes its profit plz?

Thank you very much for your help!

 

[ShaktiRathore]

Hi,
CLN issuer = short bond + long CDS. CLN means issuers sells note (bond) plus buys credit protection from the CLN investor.This means the issuer pass on any default/interest on bond to the investor of CLN. Issuer sells CDS and gets CDS spread from the protection Buyer. Thus any default on the underlying bond is passed on to the CLN investor and thus its the cln investor ends up paying for the default losses hence the CLN investor is short CDS. Thus the investor must receive the CDS spread and the bond coupon for bearing the risk of default and the bond risk inform of a high yield.
reference bond has 8% coupon, and CLN pays a 10% coupon.
So, infer: CDS spread is 2% => CDS spread of 2% +8% coupon= CLN coupon of 10% refer David: http://forum.bionicturtle.com/threads/credit-linked-note.365/
personal inference: The high yield earned by the CLN investor may not be exactly 10% as above but a little less than this 10% so that the remaining yield is the profit for the bank according to my understanding.

thanks

 

[Jeffy14]

Hi,
CLN issuer = short bond + long CDS. CLN means issuers sells note (bond) plus buys credit protection from the CLN investor.This means the issuer pass on any default/interest on bond to the investor of CLN. Issuer sells CDS and gets CDS spread from the protection Buyer. Thus any default on the underlying bond is passed on to the CLN investor and thus its the cln investor ends up paying for the default losses hence the CLN investor is short CDS. Thus the investor must receive the CDS spread and the bond coupon for bearing the risk of default and the bond risk inform of a high yield.
reference bond has 8% coupon, and CLN pays a 10% coupon.
So, infer: CDS spread is 2% => CDS spread of 2% +8% coupon= CLN coupon of 10% refer David: http://forum.bionicturtle.com/threads/credit-linked-note.365/
personal inference: The high yield earned by the CLN investor may not be exactly 10% as above but a little less than this 10% so that the remaining yield is the profit for the bank according to my understanding.

thanks

Hello,

Thank you very much for your answer!
It clarified things a lot!

Now I would really like to confirm how the bank gets its profit. I thought about what you said too and yes it's a possibility.
Another could be on the price paid for the underlying bond and the nominal of the CLN?
Could the bank buy the bond 100 and sell the CLN for a 102 nominal, thus getting 2%?

Also, what's the problem David refers to when there is a downgrade? The drawing seems to show the payment of a lower coupon in case of a downgrade. I dont see why it should happen.
A downgrading is not a Credit Event that could trigger the CDS right?
Credit Event are failure to pay, bankruptcy or restructuring.
Why is the downgrade a problem plz?

 

[ShaktiRathore]

hi,
Downgrading is not a credit event(i mean the terns of the CLN can be such that there is payoff from the protection seller in case of a downgrade) , you can think as If there is a Bond downgrade then the credit risk of bond increases manifolds so that the credit spread earned by the issuer becomes high while the CLN coupon paid still remains the same so that the issuer is now better off and at the same time investor is worse off because he is assuming the further possibility of default which is high after the downgrade which is borne by none than the investor. You see how Downgrade is really a problem for the investor but not for the issuer.
Yes credit events can be categorized into failure to pay, bankruptcy or restructuring etc.

thanks

 

[Jeffy14]

hi,
Downgrading is a credit event(i mean the terns of the CLN can be such that there is payoff from the protection seller in case of a downgrade) , you can think as If there is a Bond downgrade then the credit risk of bond increases manifolds so that the credit spread earned by the issuer becomes high while the CLN coupon paid still remains the same so that the issuer is now better off and at the same time investor is worse off because he is assuming the further possibility of default which is high after the downgrade which is borne by none than the investor. You see how Downgrade is really a problem for the investor but not for the issuer.
Yes credit events can be categorized into downgrading,failure to pay, bankruptcy or restructuring etc.

thanks

Hello ShaktiRathore,

Thx for your help again!
Look I found a new element that troubles me.
In this book he says the money receive from the CLN investor is invested in High quality collateral:

http://books.google.ae/books?id=87M...ed by collateral that is highly rated&f=false

To me it seems to make more sense. Because in case of default of the underlying, the bank has the cash to pay back its exposure in the sale of the CDS.
On the other hand, if it had invested the cash in the underlying security, the bank would be exposed twice to default and would not be able to cover its short position on the CDS.
What do you think?

 

[ShaktiRathore]

Hi jeffy,
The issuer here transfers the default risk as well as the credit risk of the bond it owns to the CLN investor. The issuer pays coupon plus the additional spread(for assuming the default risk) to the CLN investor. The cash received initially from the sale of CLN(transferring the bond holded to the CLN investor) is used to invest in the risk free asset and the coupon on the reference asset(Bond) is paid to the investor plus the additional spread. If I am not wrong the difference between the risk free rate and the additional spread is what the issuer i.e. the bank would have been making.

thanks

 

[Jeffy14]

Hi jeffy,
The issuer here transfers the default risk as well as the credit risk of the bond it owns to the CLN investor. The issuer pays coupon plus the additional spread(for assuming the default risk) to the CLN investor. The cash received initially from the sale of CLN(transferring the bond holded to the CLN investor) is used to invest in the risk free asset and the coupon on the reference asset(Bond) is paid to the investor plus the additional spread. If I am not wrong the difference between the risk free rate and the additional spread is what the issuer i.e. the bank would have been making.

thanks

Hello SHaktiRathore!

Yes you are correct this is exactly that.
Thanks a lot for your help!
I'm still not sure about how the bank makes money though.
I would like confirmation

Thx again! You were very helpful

 

[Swarnendu Pathak]

Can anyone explain the specific difference between Credit Linked Notes (CLN) & Synthetic CDO??

Thanks in advance.

 

[bpdulog]

Hi Hend,

Sorry I'm late to this thread. I think Leli's summary is excellent.

In case it helps, below is diagram from our notes/video, which is just stolen from assigned Culp (although I attached, below the Culp image, the CLN diagrams we used prior to Culp, based on Meissner). Key points:

• CLN ~= funded CDS; i.e., in both cases, "investors" sell credit protection on a reference. But CDS is unfunded (earning yield purely for default/deterioration risk), whereas CLN is funded with investor principal (earning yield for default/deterioration risk + financing/use of funds).
• CLN "is economically equivalent from the issuer's perspective to issuing a normal note plus buying credit protection from the bond investor through a CDS" (Culp)
• CLN issuer (aka, protection buyer) = short bond + long CDS; and
  CLN investor (aka, CLN buyer) = long bond + short CDS.
• Risk transfer (key difference): unfunded CDS buyer is exposed to counterparty risk and associated wrong-way risk (adverse correlation between reference and counterparty).
  However, the CLN is FUNDED so the issuer/protection buyer has virtually no counterparty risk. Instead, the CLN buyer has the counterparty risk! (i.e., like any bond buyer, issuer can default on P&I).
  So, FUNDING is the big difference: the counterparty risk switches from protection buyer to protection seller (CLN investor/CLN buyer) who ought to be compensated with additional premium (versus otherwise equivalent CDS) due to fact that funded principal at risk.
• Terminology-wise, you can see it looks to be: protection buyer/CLN issuer versus CLN buyer/CLN investor.
  As i *think* the CLN would be a security, as opposed to CDS derivative, it makes sense to me that CLN investor is a "buyer" not merely a "protection seller" because the CLN investor is purchasing issued securities. (I *think* we have a security/derivative distinction due to the funding, but not 100% sure about that).

Hi,

If I am interpreting this diagram correctly, the CLN buyer receives the recovery rate if there is a default but I don't understand why? Aren't they the credit protection seller?