Credit-linked Note - Emerging Market CLN

Emerging Market CLN

The emerging market credit linked note, also sometimes called a “clean,” are traded by buy side clients to gain access to local debt markets for several reasons. First is that a direct investment in the sovereign debt may not be legal due to domicile restrictions of the country. One instance would be the local government requiring the purchaser of debt to have a business office in the country. Another instance would be tax restrictions or tariffs in countries with NDF currencies. A fund in USD would have difficulty repatriating the currency if local restrictions or taxes made it undesirable. When this occurs, the sell side global bank purchases the debt and structures it into a derivative note then issued to the client or clients. The client then owns the issued security which derives its total return from the underlying instrument. A CDS, credit default swap, is embedded in the instrument. It can be thought of as a fully funded total return swap where the underlying asset total return is exchanged for a funding fee as well as the cost of the issued CLN. From a market risk perspective owning a CLN is almost identical to owning the local debt.

However downstream, in the back office, difficulties can arise from failure to appropriately control the risks associated from the lack of data and compatibility of accounting platforms. The issue stems from the bespoke nature of the CLN in that it is priced in USD but the underlying asset is denominated in another currency. Secondly, the sell side may price the CLN based on the issued asset in USD. This in turn does not appropriately reflect the Yield to Maturity of the underlying asset as it approaches par value at maturity. Thirdly, the underlying asset may be inflation linked, or have periodic paydowns that compound the first and third issues mentioned before.