Tutorial: Credit Linked Notes

What is a credit-linked note?

A credit-linked note (CLN) is an interest-bearing debt security whose interest payments and repayment are contingent on the financial solvency of the underlying debtor (e.g. state or company). If there is no so-called credit event, the bondholder receives attractive interest payments that are usually higher than in the case of comparable government or corporate bonds. Upon maturity, the principal of the CLN is repaid at the nominal value. In the case of a credit event, the credit-linked note is repaid prematurely and instead of the nominal value, either the liabilities of the underlying debtor (bond or loan) are allotted or the value of a reference liability is determined and paid out. The interest payment and the size of the redemption of a linear CLN hinges on the number of debtors that have incurred a credit event. Each occurrence of a credit event reduces the redemption amount as well as the interest payment (e.g. by one third in case of three debtors). A linear CLN will not be redeemed prematurely. It will be repaid at maturity.

What is a credit event?

A credit event is understood to be insolvency, default on payment or debt restructuring. This credit event refers to current and future liabilities and not only to any specific obligation (e.g. bond).

How does a credit-linked note work?

When the reference debtor meets its payment obligations as scheduled, the bondholder receives an attractive return as well as 100 percent of the invested nominal value. However, if there is a credit event (insolvency, default on payment or debt restructuring), the credit-linked note is prematurely repaid and instead of the nominal amount either a bond issued by the underlying debtor is delivered or the current value of a reference bond is determined and paid out.
The price of the reference bond will usually be quoted far below 100 percent due to the credit event. This renders tradability of the underlying liabilities difficult and weigh further on the price.
The interest payment and the size of the redemption of a linear CLN hinges on the number of debtors that have incurred a credit event. Each occurrence of a credit event reduces the redemption amount as well as the interest payment (e.g. by one third in case of three debtors). A linear CLN will not be redeemed prematurely. It will be repaid at maturity.

Your benefits

Credit-linked notes usually have higher yields than comparable government or corporate bonds. If the reference debtor meets payment obligations as scheduled, repayment of the CLN is at maturity at the nominal value. Interest payments and principal repayment are contingent on the financial solvency of the debtor though.

Your advantages

You have the opportunity to earn an attractive return that is higher than on comparable government or corporate bonds.
You profit from the prices of the credit risk of renowned companies and states.

Details you should be aware of

Interest payments and principal repayment depend on the financial solvency of the debtor.
In the case of a credit event, you must expect to lose capital. Furthermore the principal can be repaid prematurely as the case may be.
Price fluctuations are possible during the life of the bond and therefore premature selling could result in a price loss.

How do credit-linked notes react to…

… interest rates rise?
Credit-linked notes with fixed interest rates lose value at rising interest levels. If you sell these bonds before maturity, you must expect a price loss.
Credit-linked notes with variable interest profit from rising interest rates. As the interest rate of these securities is regularly adjusted (floaters) to a reference interest rate such as the Euribor, the interest they bear increases as interest rate levels rise. The price usually fluctuates around 100 percent.

… stable interest rates?
When the general interest rate level does not change, then neither does the price or the coupon on a credit-linked note

… falling interest rates?
Credit-linked notes with fixed interest rates gain value at falling interest levels. In the case of a premature sale of these bonds, you can make price gains.
Credit-linked notes with variable interest rates are negatively affected by falling interest rates, however. As the interest rate of these securities is regularly adjusted (floaters) to a reference interest rate such as the Euribor, the interest they bear decreases as interest rate levels sink. The price usually fluctuates around 100 percent.

... rising credit risk?
As the credit risk of the reference debtor increases, the price of a credit-linked note drops, because the probability of a credit event occurring grows.

... unchanging credit risk?
When the credit risk of a reference debtor does not change, no effects are expected in the price of the credit-linked note.

... sinking credit risk?
As the credit risk of the reference debtor decreases, the price of a credit-linked note rises, because there is less probability of a credit event occurring.

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