Last week, I wrote an introduction to credit default swaps.
An extension to a single CDS is a credit linked note (CLN) that has a basket of entities as the reference entities. In this case, a default will occur when the first entity in the basket defaults.
The noteholder becomes the insurer while the CLN issuer takes on the role of the insurance buyer. Retail investors have to put up the principal in case there are credit events.
The principal is then used to buy some underlying securities. In the good old days, the underlying securities could be government bonds.
This first-to-default structure means that the more entities there are in the basket, the higher the probability that a default will occur. This makes it more risky for the noteholder.
But wait, shouldn’t more entities mean more diversification? Let us look at the difference between holding normal bonds and a CLN setup.
Portfolio of Bonds
$5 million in capital is used to buy $1 million bonds from five different companies. Should there be a default, $1 million could be lost. Having more companies in the portfolio of bonds diversifies the risk.
Credit Linked Note
$5 million is provided by the note buyer. A CDS of $5 million each is written on five different companies. Total insurance written is therefore $25 million. In the event of a default by one company, up to $5 million would have to be paid out to the swap counter party. In addition, all the other 4 CDS positions will also have to be unwound.
Therefore, the more companies there are in the portfolio, the riskier the note is.
If the CLN has been structured with $1 million CDS each written on five companies (total insurance of $5 million), then it would have been similiar to the normal bond portfolio. But then, the profit to the note issuer would be much lower.