Credit-linked notes: Overview

Credit-linked note: Post-issuance cash flows

Credit-linked notes (CLNs) are financial instruments that can generally be used to simultaneously raise term funding, hedge credit risk, meet financial reporting objectives, and–in some cases–improve bank regulatory capital ratios.  Here is an outline of what perhaps every Brazilian bank executive should know about credit-linked notes:

(1) CLNs provide term funding to the CLN issuing bank and–at the same time–transfer credit risk in the CLN reference portfolio to the CLN investor in exchange for (i) interest payments at the CLN issuer’s otherwise normal term interest rate plus (ii) an additional premium payment to compensate the investor for taking on the CLN portfolio credit risk (see diagram above).

(2)  The embedded credit default swap (CDS) provisions of CLNs result in the applicability of Banco Central do Brasil Resolutions 2921 and 3082.

(3) To the CLN investor, under conditions of non-default in either the CLN reference portfolio or CLN issuer, the CLN is simply a higher-than-normal-yield investment in bank term debt.  Under conditions of default in the CLN reference portfolio, the CLN issuer is compensated to the extent of the (defined) loss resulting from the default.

(4) If certain provisions of BCB 3082 are met, the embedded CDS in the CLN is considered an effective credit risk / cash flow hedge and–therefore–mitigate reported credit losses in the CLN reference portfolio.

There are, of course, many nuances I’ve not mentioned here.  In this connection, I’ve developed a presentation used for presenting these issues to clients in somewhat more detail and would be very pleased to e-mail it to anyone interested (please respond in the comments section below, if interested).

Or, for those who would prefer to wait, I will soon write an article explaining credit-linked note risk hedging, valuation, and Brazilian regulatory reporting in more detail.

Até mais e abraços

MMc
São Paulo

Caveats.  Please note: (i) views presented above are my own and do not reflect those of others; (ii) like anyone, I’m not infallible and am responsible for any errors; (iii) I greatly appreciate being informed of any significant errors in facts, logic, or inferences and am happy to give credit to anyone doing so; (iv) the above article is subject to revision and correction; and, (v) the article cannot be construed as investment or financial advice and is intended merely for educational purposes.  MMc