Credit-linked notes: managing risk to maximise your returns
A credit-linked note (CLN) is a form of funded credit derivative.
It is structured as a security with an embedded credit default swap that allows the issuer to transfer a specific credit risk to credit investors. The issuer is not required to repay the debt if the specified credit event occurs, thus eliminating the need for third-party insurance.
Designed to offer investors par value at maturity unless the referenced entity defaults, CLNs are issued by an ad hoc company or trust. In the case of a default, the investor will receive a recovery rate.
Meanwhile, the trust will also have entered into a default swap with a dealer. In case of a default, the trust will pay the dealer par minus the recovery rate in exchange for an annual fee, which is passed on to the investor at a higher yield on his or her note.
In Thailand, investors can invest in CLNs through mutual funds. These funds generally invest in CLNs issued by foreign banks and embedded with underlying assets, such as South Korea’s government bond in won or the Thai government bond offered in foreign countries in US dollars.
Mutual funds invest in CLNs, which can create opportunities for higher returns for investors than direct investment in underlying assets with similar risk. For instance, CLNs that link returns with the Thai government bonds offered in foreign countries offer a higher yield than those offered in Thailand with the same credit risk.
For mutual funds, the Securities and Exchange Commission requires that mutual funds invest in CLNs issued by secure, stable financial institutions. Both the issuer and the underlying assets, such as government bonds or debentures, must be rated by an international credit rating agency like Standard & Poor’s (S&P) or Moody’s. In the case of S&P, the long-term credit rating of the issuer and the underlying asset must be rated at no lower than “A” and the short-term credit rating must be no lower than A-1. With this required rating, CLNs can reduce the default risk for investors.
As for the risk of investment in CLNs, their returns are based on underlying assets. Therefore, investors should consider the default risk, credit rating and financial position of the issuing country, issuer, financial institutions, and the security itself. Investors must also take into account the exchange-rate risk and consider investing in funds with a currency-exchange hedging policy to offset such risk.
In summary, CLNs represent an alternative investment for those desiring higher returns than cash deposits. CLNs are issued by secure, stable commercial banks or listed companies, both local and international.
Investment contains risk; please carefully study the fund prospectus before making your investment decision.
Jarulag Ruangsuwan is senior vice president in the marketing department of Asset Plus Fund Management.
