Some investors who cannot trade swaps use a credit-linked note to take on credit risk in the form of a bond. It is also used when a bank transfers the credit risk of loans and similar assets and secures the payment for losses in advance.

Combining a bond with a sale of protection

A credit-linked note (CLN) is a structured note that embeds a credit default swap (CDS) in a bond. The CLN investor takes the position of a protection seller that guarantees the credit risk of a particular company (the reference entity). In return, the investor receives a premium, which raises the interest on the note1. If a credit event occurs at the reference entity, the principal is not repaid in full2. The payments of a CDS itself are covered in Credit Default Swaps (CDS).

CLNs are issued in two main forms. In the first, a special purpose company (SPC) or a similar entity set up to issue CLNs is the issuer. The SPC uses the money the investors pay in to buy government or corporate bonds and issues the CLN with those bonds as collateral (some sources call them the backing assets). At the same time, the SPC sells protection through a CDS on the reference entity2. In the second, an issuer such as a financial institution issues the CLN as its own bond with a CDS embedded in it31. The example below uses the SPC form.

Take a fictional example of a CLN issued by an SPC. Company G is an SPC set up to issue CLNs. It issues a 5-year CLN to investors with a face value of 1 billion yen and Company H as the reference entity. With the 1 billion yen paid in, Company G buys government bonds with a face value of 1 billion yen and a coupon of 0.5% a year, and holds them as collateral. Company G enters into a 5-year CDS with the financial institution that structures the product (the dealer). Under the CDS, it sells protection on Company H with a notional amount of 1 billion yen. The premium is 1% a year. Interest and the CDS premium are paid once a year, and there are no structuring costs.

InvestorCLN buyerCompany GSPC; JGBsDealerCDS buyerPayment JPY 1bnCoupon, repaymentPremium 1%Pays loss
Figure 1Flows in a CLN issued by Company G, an SPC
Figure description

The investor pays Company G, the SPC, 1 billion yen for the CLN and receives interest ("Coupon" in the figure) at 1.5% a year and the redemption amount from Company G. Company G uses the 1 billion yen paid in to buy government bonds (Japanese government bonds, "JGBs" in the figure) and holds them as collateral. The dealer is the CDS counterparty and the protection buyer ("CDS buyer" in the figure). It pays Company G a premium of 1% a year on the CDS with Company H as the reference entity. It receives a payment from Company G if a credit event occurs at Company H. The investor is not a party to the CDS, but the CLN puts the investor in the position of a protection seller.

Interest and redemption payments

If no credit event occurs, the investor receives interest every year and is repaid at face value at maturity. The interest of 1.5% a year in the example is the sum of the 0.5% a year on the collateral government bonds and the 1% a year CDS premium. Each year's interest is 1 billion yen × 1.5% = 15 million yen, or 75 million yen over 5 years. In the worked example in a Bank of Japan training document, the amount added to the investor's interest (α) is smaller than the CDS premium (β)1.

If a credit event occurs, the CLN is redeemed at an amount based on the market value of the reference entity's debt or a similar measure2. The collateral bonds are the source of the payment to the protection buyer4. In the example, suppose a credit event occurs at Company H after the interest payment at 2 years, and the price of Company H's debt is set at 40% of face value. Company G sells the collateral government bonds and pays the dealer 1 billion yen × (100% − 40%) = 600 million yen. If the government bonds sell at their face value of 1 billion yen, the remaining 400 million yen goes to the investor as the redemption amount. The timing of redemption depends on the terms of the CLN. The examples in a Federal Reserve guide from September 2001 include both a form in which each CLN hit by an event is redeemed at that time and a form in which the settlement of losses waits until maturity, whenever the event occurs4. The procedure that sets the price of the debt (the auction) is covered in Credit Events and Settlement.

↑ Receive　↓ PayThe investor who bought the CLNIssue dateYear 1Year 2After event−JPY 1bnPurchase price+JPY 15mnInterest+JPY 15mnInterest+JPY 400mnRedemption
Figure 2The investor's payments and receipts when a credit event occurs after the interest payment at 2 years
Figure description

The figure shows the payments and receipts of the investor who bought the CLN. The investor pays the purchase price of 1 billion yen on the issue date and receives 15 million yen of interest at 1 year and again at 2 years. After the interest payment at 2 years, a credit event occurs at Company H. If the price of Company H's debt is set at 40% of face value, the investor is repaid 400 million yen ("After event" in the figure). No further interest is paid. The length of each arrow is a rough guide to the size of the amount.

The investor's profit or loss depends on whether an event occurs, as follows. For comparison, the table also shows the profit or loss from holding only government bonds with the same 1 billion yen for 5 years.

Case Total received by the investor (million yen) Investor's profit or loss (million yen) Profit or loss from holding only government bonds (million yen)
No event for 5 years 1,075 +75 +25
Event after the interest payment at 2 years (price 40%) 430 −570 +25

If no event occurs, the investor receives 50 million yen more than by holding only government bonds. This 50 million yen is the premium for taking on Company H's credit risk. If an event occurs, the investor receives only 30 million yen of interest and the 400 million yen redemption amount, and loses 570 million yen.

The reference entity's credit quality and selling before maturity

Through the embedded sale of protection, the value of a CLN changes with the credit quality of the reference entity. The market value of a CDS changes with the difference between the premium rate fixed at the trade date and the current spread on a CDS with the same terms5. In the example, suppose Company H's business worsens and the spread on a CDS with the same terms rises to 3% a year, against the 1% a year premium fixed at the trade date. The embedded CDS loses value, and the CLN price falls below face value. If the investor sells before maturity, the investor incurs a loss even though no event has occurred. If Company H's credit quality improves and the spread falls, the CLN price rises.

Some structured products have low liquidity, and selling them after purchase may be restricted6. This difficulty in selling is a risk shared by structured products in general and is covered in What Are Structured Products?

Uses

For investors, a CLN is a way to take on credit risk in a form similar to a corporate bond and earn extra interest. A CLN synthetically replicates a corporate bond by embedding a CDS, and it is sometimes used by investors who cannot trade swaps7. Investors can take on the reference entity's credit risk without buying its debt directly8. On the other hand, as the example above shows, the investor can lose most of the principal if an event occurs at the reference entity.

For the protection buyer, a CLN is a way to transfer credit risk and secure the payment for it in advance. The Federal Reserve guide gives an example in which a bank transfers the credit risk of loans and other assets to an SPC through a CDS, and the SPC uses the money raised by issuing CLNs to buy U.S. Treasury securities. The Treasury securities are pledged to the bank to cover loss payments4.

Three credit risks the investor bears

On top of the reference entity's credit risk, the CLN investor bears the credit risk of the parties that support the payment of principal and interest. According to the JCR methodology, the principal and interest of a CLN issued by an SPC are supported by three elements: the collateral bonds, the reference entity, and the CDS counterparty10.

If a credit event occurs at the reference entity, the investor's principal is not repaid in full11. This is the risk the investor takes on in return for the premium, and the 570 million yen loss in the example is an instance of it.

If the issuer of the collateral bonds cannot pay, less money is available for the CLN's interest and redemption. This is because the interest, the redemption, and the costs of maintaining the structure of a CLN issued by an SPC are first paid out of the cash flows from the collateral bonds12. When a financial institution or similar entity issues the CLN itself, the investor bears that issuer's credit risk instead of the collateral bonds'3.

If the CDS counterparty defaults, the CDS contract is usually terminated early, and the CLN is redeemed before maturity at less than the principal, JCR expects13. JCR also expects the investor's interests to be harmed even if no event has occurred at the reference entity.

The SPC and managing the collateral

According to the JCR methodology, some products tie their credit risk to the credit of another company through a CDS or similar contract (called credit-linked products in the source). These are issued through vehicles such as trusts, limited liability companies established in Japan under the Companies Act, and special purpose companies established outside Japan. Credit-linked products are sold to investors in the form of bonds (CLNs), trust beneficiary rights, or loans2. SPCs in the Cayman Islands are often used as the issuer of the bonds9.

The SPC is kept free of any risks other than those involved in issuing the CLN, so that it avoids unexpected bankruptcy proceedings. This is called bankruptcy remoteness. The SPC's business is limited to buying the collateral bonds, issuing the CLN and paying its interest and redemption, and entering into swaps and other contracts14. When one SPC issues several products, the cash flows are separated by product series. Even if another series defaults, the cash flows of this CLN are kept out of reach of the claims of that series' creditors. This arrangement is called ring-fencing9.

Differences from selling protection through a CDS

Buying a CLN and selling protection through a CDS both take on the reference entity's credit risk, but they differ in the following ways.

Item Buying a CLN Selling protection through a CDS
Form of the trade and funds at the start A bond with an embedded CDS. The investor pays the face value up front (funded)7 A derivative contract. No payment of face value up front (unfunded)16
Whether the protection buyer can be paid Secured by collateral bought with the investor's payment4 In a bilateral trade without collateral, the buyer may not be paid if the seller fails (a source from around the 2008 financial crisis)1718

For the protection buyer, a CLN secures the money for the payment in advance, so the seller's credit risk is smaller than in a bilateral CDS without collateral. The credit risks the investor bears are described in the section "Three credit risks the investor bears" above.

Notes

  1. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), pages 13–14, the worked example of a CLN and the chart "基本的な仕組み" (Basic structure) ("※α＜β"). ↩ ↩2 ↩3

  2. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (Credit-linked products, in Japanese; last updated December 3, 2012), page 1, "1. クレジットリンク商品" (1. Credit-linked products) and Charts 1 and 2. The source calls the reference entity "参照体" (reference entity). ↩ ↩2 ↩3 ↩4

  3. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 2, "金融法人が発行体になる場合" (When a financial institution is the issuer) in "(1) 格付の枠組み" ((1) Rating framework). ↩ ↩2

  4. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 4353.1 "Collateralized Loan Obligations" (page dated September 2001, page 4; page 74 of the PDF). An example of a synthetic CLO. ↩ ↩2 ↩3 ↩4

  5. OpenGamma Quantitative Research, "The Pricing and Risk Management of Credit Default Swaps, with a Focus on the ISDA Model" (October 2013), Sections 2.2 and 4.5 (pages 3 and 10). Equation (28) is the buyer's market value; the seller's has the opposite sign. ↩

  6. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), page 15, "（1）シナリオ分析の重要性" ((1) The importance of scenario analysis). ↩

  7. IHS Markit, "CDS Indices Primer" (November 2021), page 13, "Credit Linked Notes." ↩ ↩2

  8. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 4350.1 "Credit Derivatives," "Uses" (page dated April 2003, page 4; page 64 of the PDF). ↩

  9. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 4, "(5) 投資家へのキャッシュフローの確保" ((5) Securing cash flows to investors), and page 6, "① キャッシュフローのマッチング" (1. Cash flow matching) in "(7) その他のポイント" ((7) Other points). ↩ ↩2 ↩3

  10. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 2, "(1) 格付の枠組み" ((1) Rating framework) in "2. 格付のポイント" (2. Key rating points). The source calls the CDS counterparty "スワップカウンターパーティ" (swap counterparty). ↩ ↩2 ↩3

  11. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 3, "(3) 参照体の格付" ((3) Rating of the reference entity). ↩

  12. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 3, "(2) 裏付資産の格付（信用力）" ((2) Rating (creditworthiness) of the backing assets). ↩

  13. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 3, "(4) スワップカウンターパーティの格付（契約履行能力）" ((4) Rating (ability to perform the contract) of the swap counterparty). ↩

  14. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 5, "(6) SPC の倒産隔離" ((6) Bankruptcy remoteness of the SPC) and Chart 3. ↩

  15. Japan Credit Rating Agency, Ltd., "クレジットリンク商品" (in Japanese), page 5, item ② of "(5) 投資家へのキャッシュフローの確保" ((5) Securing cash flows to investors). ↩

  16. IHS Markit, "CDS Indices Primer" (November 2021), page 8, footnote 8 ("CDS are unfunded"). ↩

  17. 吉井一洋, "クレジット市場における検討課題" (Issues to consider in the credit market, in Japanese; Financial Research and Training Center, Financial Services Agency, July 2009), "5.2.1 2008 年金融危機と集中清算機関設立の提言" (5.2.1 The 2008 financial crisis and the proposal to set up a central clearing house), page 47. The source notes that it gives the author's personal views and not the official views of the Financial Services Agency. ↩

  18. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 4350.1 "Credit Derivatives," "Credit Risk" (page dated April 2003, page 7; page 67 of the PDF). ↩