Credit Linked Note

Structured finance products have proliferated the financial markets. There are several derivative products that have been created with the sole intention of helping a company transfer its credit risk onto another company or group of investors who are willing to assume this risk.

The most well-known and common structured finance product which enables companies to do this is called the credit default swap. However, credit default swaps are considered to be a risk. They almost caused the bankruptcy of some big-ticket firms like AIG in the recent past. This is the reason that the internal guidelines of many organizations do not allow them to issue or trade-in credit default swaps. However, there is a need for them to transfer their risks to third parties. As a result, a more conservative product called credit-linked note has been created. A credit-linked note is considered to be much safer and hence is allowed as per the guidelines of most companies around the world.

In this article, we will have a closer look at what a credit note is and how it works to eliminate credit risk.

What is a Credit Linked Note?

A credit-linked note is a financial product that allows a company to remove the credit risk of a fixed income instrument that they have purchased. Let’s say that company A wants to buy bonds issued by company B. However, company A is afraid that B might default or that there might be a downgrade in their credit profile. Hence, they don’t want to keep the credit risk on their books. They want to transfer it to a third party. Now, a group of investors called C are willing to take on the risk of default.

The purpose of a credit note is to ensure that only the credit risk of the purchase is transferred from the original buyer (A) to a group of investors (C). Other risks such as market risks will continue to remain with the original buyer (A).

How Does a Credit Linked Note Work?

A credit-linked note can be created in three steps:

In the first step, company A pays cash to company B in order to buy bonds from them. In return, company B promises to make periodic payments for principal and interest
In the second step, the investor i.e. company A pools their bonds and creates an underlying portfolio. This portfolio is called the reference asset base.
In the last step, company A issues another set of securities backed by the bonds of company B. They sell these securities to investors C who pay for them upfront. In return, company A also promises periodic payments. These payments are higher as they include a markup that has to be paid to C for taking on the credit risk.

It is important to notice that company A is out of the transaction as far as the credit risk is concerned. On the one hand, they gave money to B, and on the other hand, they received money from C. Hence, their exposure is nil. Similarly, for the periodic payments, A will receive money from B, add a percentage to compensate C for taking credit risk, and pay it to C. Hence, A’s interests are protected in almost every scenario. Let’s take a look at how the situation will turn out in different scenarios.