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:

1. 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

2. 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.

3. 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.

Credit Linked Note: Scenarios

1. No Default: The first scenario is also the most common one. Most of the time, companies issuing debt pay back the principal as well as interest on time. In such a scenario, company A would take money from B and pay to C after adding a markup. They would only lose the additional markup. However, that would be like an insurance premium and hence A is willing to write it off. So, if they receive 7% interest in coupon payments and pay 7.25% to C, they are losing 0.25% in lieu of the protection. This is how these transactions turn out more than 90% of the time.

2. Default: It is possible that there may be a default i.e. company B cannot pay company A. In this case, also, company A is protected. This is because they took the money upfront from company C. Hence, they don’t have any exposure. The exposure is actually with company C. In such situations, A does not have to pay back C unless they receive money from B. Also, they only have to pay the residual value. In effect, they are just a pass-through entity. Any money that comes from B will be routed to C.

3. Downgrade: In some cases, the default is not outright, instead there is a downgrade. A downgrade implies a lower effective interest rate. In such cases also, company A just acts like a pass-through entity. The decreased interest rate is simply passed on to C who has to absorb the loss.

The bottom line is that credit-linked notes ensure that none of the credit events happening at Company B impact company A. The risk has been passed on to company C for a fee! It needs to be noted that other risks such as the risk of change in the market value of the bond due to interest rate fluctuations still remain with company A. It is only the credit risk that has been transferred.