Dealers estimate that the credit-linked note (CLN) sector makes up between 10% and 15% of the MTN private placement market and it is growing steadily. Trading in credit default swaps has increased dramatically in the past year and this goes hand in hand with the CLN market. But as the structure becomes more prevalent some concerns have been raised about the way it is documented and the transparency of the credit risk. Alex Haidas at JPMorgan's risk transformation group says: "The CLN market has established itself - there are large volumes and the market distinguishes between CLN and plain vanilla issuance. It is a growing market, still mainly for sophisticated investors who can see straight through the structure and assess the credit exposure themselves. For example, in single-name CLNs, the investor is exposed to the credit worthiness of both the issuer and that of the reference entity." Anthony Everill, at Merrill Lynch, adds: "There are a reasonable amount of people willing to issue CLNs - they are mainly sophisticated issuers because they have the time and expertise to monitor the notes." But Karl Bergqwist, head of fixed income credit investment at Barclays Global Investors (BGI) - one of the biggest investors in the UK - thinks that CLNs are not the easiest of structures to monitor and document. He says: "Our simple philosophy is we never invest in something we do not understand. We avoid getting involved too much in CLNs because it is a very time-consuming investment that is inherently difficult to monitor. And some of the structures are not quite as robust as we would like." One concern is that some investors may not be aware of the credit risk their portfolio is exposed to when the reference entity suffers a credit event. Neelam Desai is an analyst responsible for repackaged securities at Moody's. She says: "Moody's is keen to emphasize that the rating on a specific credit-linked note may be different from the MTN programme rating. Investors should not assume that the programme rating is the same as the rating for the credit-linked note." But many dealers feel that this is not a problem and that the investor is fully aware of the credit risk. Deutsche Bank is one of the leading dealers of CLNs and Chris Jones, head of the Euro-MTN trading desk at the bank, says: "Most credit agencies shy away from rating CLNs, but sophisticated investors are the only ones we deal with for these structures so they are already aware of the credit risk. There are significant disclaimers in the documentation to make sure that the CLNs are not sold on to investors who are not aware of the structure." And dealers are confident that investors are familiar with the credit exposure, mainly because bookrunners spend time ensuring that the investor is comfortable with the credit risk of the structure before the note is issued. Tim Webb is fixed income portfolio manager at BGI and he supports this point. He says: "Dealers are keen to help you understand and explain these deals, although you have to bear in mind that the dealer makes a lot of money off the trade." However, the concern is not just at the outset of the note but also during the life of the note. There is a process by which the note holder is notified if the reference entity experiences a credit event, but this is not done directly through the rating agency or the bookrunner. The note's arranger or counterparty will notify the clearing system, which will in turn notify the note holder. And some suggest that this process needs to be speeded up. Bergqwist, at BGI, says: "The Enron situation is a good example. People who held exposure to Enron credit in a complex structure scrambled to find out exactly what credit exposure they had in their portfolios. The documentation does not make that easy." However if the note is done via an SPV it is easier for the investor to keep track of it. Chris Such is product manager for consumer ABS and repackaged vehicles at Standard & Poor's. He says: "If the trade is done off an SPV then it is normally investor driven and the investor will know exactly the risk it is taking because it has requested that risk and the trade has been especially repackaged for it."
February 01, 2002
