Credit-linked notes: Providing flexibility and returns in a high-rate environment

Fixed-rate investments continue to gain popularity in a high-interest-rate environment, with Credit Linked Notes (CLNs) offering improved yields to investors willing to take on additional up-front risk. Samuel Cornut, Global Co-Head of Credit Trading and Eric Elbaz, Global Head of Credit Sales, explore the benefits the product can provide as part of a diversified portfolio.

Offering strong returns, flexibility and the option to tailor features to an investor’s specific goals, credit-linked notes (CLNs) have risen in prominence in recent years. While they are similar to bonds in that they take on the risk of an entity in exchange for a coupon, CLNs are a type of synthetic credit exposure– issued by the bank or created through a special purpose vehicle (SPV) and collateralised with securities based on the investor’s risk appetite.

The product's structure incorporates a credit default swap, meaning the issuer can shift the credit risk to the investor such as bankruptcy or failure to pay on the part of the reference entity. In exchange for taking on additional risk through exposure to the underlying, investors are rewarded with greater returns than offered by more traditional fixed-income securities.

For a long time, the low-interest rate environment meant that fixed-income products were less popular amongst investors, with returns determined, in part, by the benchmark rate. However, in 2022 and 2023, market turbulence saw inflation rise and interest rates climb significantly. Over the same period, the equity market significantly outperformed expectations, giving investors excess cash to reinvest.

In turn, investors have increasingly turned to the fixed-income market as a way of diversifying their portfolios and optimising returns. However, tightening regulations and resultant internal constraints mean that traditional fixed-income products – such as bonds – often do not offer the flexibility needed to meet the increasingly complex and specific investment requirements.

CLNs, on the other hand, give investors the option to specifically tailor their investments to suit their risk appetite and individual strategies. And, while interest rates are still high, inflation is now trending downward, creating the perfect storm for the CLN market: investors are able to lock in their investments at a higher rate. Then, if and when interest rates begin to fall, borrowers would be less likely to default – minimising potential overall credit risks.

Flexibility is the defining advantage of CLNs. Investors have the option to choose both the underlying and the payoff, targeting a range of underlying reference entity exposure, maturities and structures – including loans, bonds and asset-backed securities. This gives investors the opportunity to spread their credit risk across a range of issuers and sectors, minimising the potential impact of individual credit events.

There are several mechanisms that banks can apply to CLNs to meet specific investment needs. Some, for instance, have a callable function that allows the issuer to bring forward the maturity date of the CLN at certain checkpoints based on pre-defined conditions. If this happens, investors benefit from an above-market interest rate, maximising returns.

Another popular mechanism is the Resettable Digital CLN, which requires the credit spread to remain under a certain percentage but will only suspend coupon payments for the period if the threshold is exceeded – giving investors protection against short-lived Barrier Trigger Events and an improved coupon during periods of market stability. This model means that investors are not overly punished for brief market fluctuations.

Certain banks also place a balloon function in their CLNs, withholding coupon payments until maturity. The investor benefits from compounding interest on the coupon while the bank offloads more risk by avoiding regular payouts. All of these functions can be adjusted or combined to meet the client’s needs, giving investors full control over their strategy.

With the market steadily growing and an increasingly diverse pool of investors targeting the product, the outlook for CLNs is certainly positive. Elevated interest rates and an increasingly dynamic regulatory environment will continue to contribute ongoing market uncertainty, meaning products such as CLNs will play an important role in a diversified portfolio.