Guru Speak

To provide yield enhancement for fixedincome investors, assetmanagement companies have introduced fixedincome funds invested in creditlinked notes (CLN).

We then should get to know more about CLNs.

A credit-linked note is a funded credit derivative embedded with credit default swap (CDS).

This allows the CLN issuer, or buyer of the CDS, to transfer a specific credit risk to the CLN investor, or seller of the CDS.

The purpose of this arrangement is for issuers of CLNs to pass the risk of specific default onto CLN investors willing to bear that risk in return for the higher yield compared to regular fixedincome instruments.

CLNs are designed to offer investors par value at maturity unless the referenced entity has a specified credit event such as payment default. The CLN is typically backed by very highly rated collateral, such as US Treasury securities and top three ratings of ECPs.

In the case of default of the reference entity, the CLN issuer is not obligated to repay the debt and CDS contracts can either be physically settled or cash settled.

Physical settlement is when the CLN investor pays the CLN issuer at par value, and in return takes delivery of a debt obligation of the reference entity.

With cash settlement, the CLN investor pays the CLN issuer the difference between par value and the market price of a debt obligation of the reference entity. The latter is more practical for investors in the CLN through a mutual fund.

As indicated in the prior paragraph, CLN investors have to be aware that besides the CLN issuer's credit risk, they also take on the credit risk of the reference entity.

Since most CDS are in US currency, Thai CLN investors also have to bear foreigncurrency risk.

This risk can be fully hedged by the fund manager entering into a currency swap contract, but this leads to another risk, which is counterparty risk, so investors will also have to check with the asset management company about their swap contract counterparty.

In summary, investors have to be fully aware of the risks involved in investing in this particular type of asset. For fixedincome investors, besides interest rate risk, liquidity risk and country risk, we have to know whose credit risks we are taking on (issuers of the notes and/or reference entity for the CLN) and for nonbaht notes, investors also take on the currency risk and counterparty risk for the currency swap contract.