Credit Linked Note

1. Current situation of the market interest rate

The bond titles are debt instruments used as government entities or companies to gather capital. When an investor buys bonds, he lends money to the issuer in exchange of periodic payments of interest of interest and refund of the nominal value upon expiry. The interest rate for a bond, also known as voucher, represents the investor’s profit. This rate can be fixed, remaining unvaried for the whole duration of the bond, or variable, changing based on specific indexes or referral rates.

The bond market is influenced by different factors such as central banks politics, inflation, economic expectations and the dynamic between demand and offer. The changes within interest rates have a direct impact on existing bond prices: a rise of interest rates tends to reduce prices, while a decrease makes them rise.

These aspects of interest rates within bonds are fundamental when considering the Credit Linked Note, which are financial tools structured to combine a bond with a credit derivate. A CLN revenue is tied to the credit risk or a referred entity such as a company or a government. For this reason, interest rates influence the CLN both by the bond component and indirectly. as they influence the perception of credit risk. Moreover, the interest paid by a CLN is usually higher than a simple bond. 

The investors often use CLN as diversification tool, thanks to their exposition to credit risks which are different than traditional bonds. Comprehending interest rates is crucial to evaluate risk and potential CLN revenue.

In the current context of financial markets, the recent data on revenue curves and interest rates trends play a fundamental role, mainly when considering complex products such as CLN. A needed starting point is the spread analysis between Treasury titles USA by 10 and 2 years, which as of January 5th 2024, sat at -0,35%. This negative spread is meaningful as it shows a reverse trend within revenues, a phenomenon often connected to economic slow downs or recessions.

A relevant data is the USA Treasury Bond revenue by 10 years, which used to be 4,05% on January 7th, 2024. Such interest rate is a crucial point for the global bond market, influencing a wide range of financial instruments, including CLN. The Treasury Bond revenue is monitored very carefully by the investors, as it reflects not only inflation expectations and economical growth but also monetary politics put in place by central banks.

In January 2024, the corporate bond market based in the USA has shown a strong year kick off, followed by a forecast of issuance slowing down. The first week of the year saw an important bod issuance with high rating, around $59B, exceeding predictions oscillating between $50 and $55B. Such a strong start has been led by companies with elevated rating which tried to take advantage of loan costs relatively lower and to a decrease in revenue experienced by the Treasury by the end of 2023.

However, the economic data released have sent contrasting signals and have led to significant movements in the revenue made by the Treasury, influencing expectations for new bond issuances.

Despite such prediction of slowing down, we expect a consistent flux of new issuances of bonds in January 2024, as the loan costs remain lower than the last quarter of 2023. The average indexes revenue were 5,3% on January 4th, against 5,88% in Q4 of 2023. Moreover, investors stay attracted by high quality bonds, as shown by the flux of $5B in funds and ETF correlated in the week ending January 3rd.

In a economic context in which we predict the interest rate to reduce by the central bank, the investors are facing a strategic opportunity with CLN. This possible scenario were interest rates are cut, generally used to stimulate the economy in stagnant times, leads to lower revenues on bonds. As a consequence, buying a CLN now could mean blocking a revenue interest which could be higher than what we could reach in the future, when interest rates could potentially be lower.

In synthesis, the current prediction of interest rates cuts by the central bank represents a unique opportunity for CLN investors. Blocking a higher interest rate now with a CLN, considering both its solidity in CLN issuer both in title quality, could result in an interesting investment strategy. However, as always in the financial sector, every investment decision should be carefully considered with relations to its goals and risk tolerance.

2. How do Credit Linked Notes work?

The Credit Linked Certificates (CLC) represent financial tools which are innovative and offer investors a unique chance to take part in the credit market, benefiting from financial solidity of different referral entities, as companies, financial institutions or government bodies.

These tools, characterised by flexibility and diversity in their conditions, allow investors to gain periodic prizes, both with fixed and variable amount, on monthly, quarterly or annual payments.

The main attractiveness of CLC resides in their ability to generate periodic revenue based on credit merit of the entities involved. For the investors looking for a consistent revenue and trust financial stability for their referral entities, these tools can prive and interesting investment opportunity. Moreover, the terms variety and available conditions allow a certain measure of customisation based on preferences and investor’s needs.

While it is true that CLC bring some risks, such as issuer’s credit risk and referral entity, and do not offer a guarantee of capital protection, they represent a vital and dynamic part of financial investments panorama. The informed and aware investors can use these tools to diversify portfolios and can catch unique revenue opportunities.

To ensure a complete understanding and an aware investment decisions, it is essential to carefully examine the legal documentations, which provides details based on characteristics, risks and associated costs to these complex financial products.

The CLN allow:

  • investors to acquire indirectly credit exposition for subjects which are traditionally outside their ray of action. This means investors can diversify their portfolios investing in debts owned by people they do not have direct contact with, such as companies or governments not issuing bonds directly or titles in the same market as the investor. This type of exposition can be useful for investors looking to expand their ray of action beyond traditional markets or local ones, allowing them to have access o a wider pool of assets and profiles of risk-revenue.
  • Financial intermediaries, can lead a more active management and more efficient than their credit risk. This happens via ‘securitization’ of risk and credit, turning them into a negotiable title which can be sold to investors
    • This process allows intermediaries to distribute non-fulfilment risk on a wider number of subjects, reducing the potential impact of non-fulfilment on a single entity.
    • Moreover, it provides intermediaries a bigger flexibility in their balance, as they can convert illiquid credit risk (such as a loan) in a more liquid and negotiable title.

In Italy, CLC are financial instruments which are negotiable on the SeDeX and EuroTLX platforms, both managed by Borsa Italiana. The rules and times for negotiations are described in official guidelines, available on their website. For example, real time trading is possible in the days where the market is open, from 9.05am to 5.30pm, for SeDeX and from 9am to 5.30pm for EuroTLX.

The value trend for CLC is strictly connected to the credit merit evaluation of the underlying active. These tools are characterised by different key elements:

  • Expiration: the date when the certificate ends its validity
  • Issue: financial entity responsible for Certificate issuance
  • Minimum Lot: minimum number of Certificates that can be sold or bought
  • ISIN: unique code alphanumeric which identifies the Certificate
  • Reference Entity: One or more companies, financial institutions or extra national entities which are object of Credit Linked
  • Credit Event: events like failure, missed payment or debt restructuring, which lead to losing capital protection and payment interruption for periodic prizes
  • Periodic prizes: the fixed import paid to the investor, given that a credit event does not occur. Moreover, for CLC that cover a company basket, the refund varies based on the event affecting one or more or all of the reference entities involved. This determines the refund amount owed to the investor
  • Minimum payment upon expiration: the minimum percentage for price issuance of the Certificate which is refunded to the investor in case of credit event.
  • Effective recovery: the real value which is recognised to the investor after manifestation of a credit event determined by the market
  • Null recovery: specific condition for some CLC in which, following  a credit event, the investor loses the whole invested capital upon expiration.

3. CLN example

Let’s take into consideration a CLC having as reference entity a specific company. The certificate is issued March 15th 2015 with an issue price of 100 EUR, 5 year duration and an annual prize of 6 euros. If a credit event was to happen, the minimum payment upon expiration is 50% of the issue value of the Certificate. Here are the possible scenarios for the investor.

No credit event:

  • 15 March 2016: the investor receives 6 euros;
  • 15 March 2017: the investor receives another payment of 6 euro;
  • 15 March 2018: the investor receives 6 euro;
  • 15 March 2019: the investor receives 6 euro;
  • 15 March 2020: the investor receives 6 euro plus refund of 100 euros, equal as the issue value of the certificate.

Credit event third year:

  • 15 March 2016: the investor receives 6 euro;
  • 15 March 2017: the investor receives 6 euro;
  • 15 March 2018: no payment due to credit event;
  • 15 March 2019: no payment;
  • 15 March 2020: the investor receives 50 euro, equal to 50% of the issue price

Credit Event first year

  • 15 March 2016: no payment due to credit event;
  • 15 March 2017: no payment;
  • 15 March 2018: no payment;
  • 15 March 2019: no payment;
  • 15 March 2020: the investor receives 50 euro, equal to 50% of the issue price.

Thanks to a CLC an investor has a right to receive a periodic voucher if conditions are respected, in case of credit event he is still protected by the issuer who covers part of the loss. Differently from the certificate, in case of insolvency, the obligation would lose all of its value.

Different are the real cases that would be significant, one of these being a CLN on a 3-year basis, with BTP underlying, which is the good part of the Italian treasury, making 0,44% more than a simple underlying.

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