Let's take a look at credit linked Notes or cns.
These structured products combine a standard bond with the credit risk exposure of another reference entity achieved by embedding a credit default swap or CDS within the structure.
In this example, alpha Bank issues a five year CLN linked to the credit performance of cargo.
The investor receives semi-annual coupon payments of 7.5% per year, and if no credit event occurs, the full return of their principle at maturity.
However, if CAR co experiences a credit event during the life of the note coupon payments stop and the investor's principle is adjusted based on the recovery rate of the reference car co bond.
In other words, in the event of default, the investor bears the credit risk and their final payout depends on the post default value of CAR CO's bonds.
So why would a bank issue ACL N? There are several benefits.
First, it provides an alternative funding source By issuing A CLN instead of standard debt, the bank effectively secures funding at the coupon rate on the CNN's net of the CDS premium on cargo reducing their effective funding cost.
In this example, the CLN pays a 7.5% annual coupon to investors.
Since the structure embeds A CDS on cargo, the investor is effectively selling credit protection to the bank.
The investor has agreed to suffer a loss if there is a default event for which they would otherwise require a payment referred to as the credit spread.
This means the bank is buying protection on car CO's credit risk while simultaneously raising funds.
If the five year CDS spread for CAR CO is 225 basis points, the bank effectively raises funds at a net cost of five and a quarter percent.
This is the 7.5% coupon paid to investors minus the two and a percent cost of credit protection.
This means that only five and a quarter percent of the 7.5% coupon is being used to cover the funding cost of the funds raised with the other two and a quarter percent paying for the credit protection.
If the bank's usual funding cost from long-term deposits or bond issuance are higher than five and a quarter percent, issuing the CLN provides a more attractive Financing alternative.
Another key advantage for the bank is credit risk transfer.
If the bank has existing loan exposure to CAR Co and is concerned about the credit risk, but the CDS market for CAR CO is too illiquid to hedge effectively issuing A CLN allows them to transfer that risk to investors.
Instead of retaining the risk on their books, the bank passes it to the CLN holders who receive the higher coupon In exchange for assuming that risk.
Additionally, banks may issue CRNs simply to facilitate client demand, offering an attractive credit linked investment that aligns with investor preferences.
For investors considering CNS counterparty risk is an important factor.
If the CLN is issued directly by the bank, investors not only take on Coco's credit risk, but also the bank's credit risk.
In other words, if the issuing bank defaults, the investor could be exposed to losses, even if Coco remains credit worthy.
To address this, CNS can be structured in different ways.
One common approach is to structure the CLN using high rated bonds such as government bonds or supernational debt combined with a CDS on caco.
This means the investor no longer has exposure to the structuring banks credit risk.
Instead, their exposure is to the issuer of the high rated bond and to KACO's credit risk through the embedded CDS, these bonds and CDS are typically placed in a special purpose entity ensuring that the structure remains legally separate from the bank's balance sheet.
Ultimately, credit linked notes offer a flexible way to gain exposure to credit markets, whether for banks seeking efficient funding and risk management solutions, or for investors looking to capture additional yield by assuming targeted credit exposure.
