CLN and CDS
- Thread starter kunduanil
- Start date
Great point, suhail!
Setting aside there can be different CDS types (Meissner; e.g., basket CDS) and the nomenclature in regard to CLNs seems to vary a bit in practice (some seem to imply that a CLN is issued by the reference firm), I follow Culp (Securitization):
* Number of assets is not a criteria: both CDS and CLN can *reference* a single-name (e.g., single name CDS) or multiple names (though i don't know how much in practice the CLNs do?)
* They only salient difference is FUNDED STATUS. See here. Similar to suhails' point.
In the case of a CDS, the protection buyer incurs counterparty risk (what if the protection seller defaults after the credit trigger?) due to the unfunded status of the CDS but, in the CLN, the protection seller receives the proceeds up front and does not have the counterparty risk.
David
Setting aside there can be different CDS types (Meissner; e.g., basket CDS) and the nomenclature in regard to CLNs seems to vary a bit in practice (some seem to imply that a CLN is issued by the reference firm), I follow Culp (Securitization):
* Number of assets is not a criteria: both CDS and CLN can *reference* a single-name (e.g., single name CDS) or multiple names (though i don't know how much in practice the CLNs do?)
* They only salient difference is FUNDED STATUS. See here. Similar to suhails' point.
In the case of a CDS, the protection buyer incurs counterparty risk (what if the protection seller defaults after the credit trigger?) due to the unfunded status of the CDS but, in the CLN, the protection seller receives the proceeds up front and does not have the counterparty risk.
David
I just want to check that my thinking here is correct...
The buyer of the CLN pays cash (thus funding the credit transfer for the issuer of CLN) and receives higher yield for taking credit risk but doesn't the CLN buyer also have counterparty risk that the CLN issuer can't pay the coupons or the recovery in the case of default?
The CLN issuer has transfered credit risk to the CLN buyer & receives cash and invests this in a risk free asset.
If the bond gets downgraded...the CLN issuer benefits as it receives a higher coupon from the referenced bond and pays a lesser coupon payment to the CLN buyer.
If the bond defaults...the CLN issuer pays the recovery to the CLN buyer (since the CLN issuer already received cash from CLN buyer it has effectively transferred the loss due to default to the CLN buyer but it loses future coupon income).
Thus, the CLN issuer's worst case scenario is that the credit sensitive bond actually performs well and doesn't downgrade or default because it is paying a higher coupon (sort of like paying the premium when buying a CDS) than it is receiving from the referenced bond and it only invested the cash in a Risk Free Asset (thus resulting in a return less than the risk free investment?)
If someone owned credit sensitive assets and wanted to reduce credit exposure, one could issue a CLN or buy CDS (pay insurance like premium but would also have counterparty risk). It seems that CDS has been the more popular alternative but perhaps CLNs may be a better if one actually considers counterparty risk from purchasing a CDS given that when a credit event is triggered? Especially if a downgrade is highly likely it would seem that a CLN would be a safer hedge (due to less counterparty exposure) but not sure what the market is like for buyers of CLNs (secondary markets, liquidity). Perhaps issuing a CLN is more costly and more difficult than buying a CDS (i.e. the higher coupon payment is more than the premium for CDS)?
Please correct me or add to this if anyone has any comments. Thanks.
The buyer of the CLN pays cash (thus funding the credit transfer for the issuer of CLN) and receives higher yield for taking credit risk but doesn't the CLN buyer also have counterparty risk that the CLN issuer can't pay the coupons or the recovery in the case of default?
The CLN issuer has transfered credit risk to the CLN buyer & receives cash and invests this in a risk free asset.
If the bond gets downgraded...the CLN issuer benefits as it receives a higher coupon from the referenced bond and pays a lesser coupon payment to the CLN buyer.
If the bond defaults...the CLN issuer pays the recovery to the CLN buyer (since the CLN issuer already received cash from CLN buyer it has effectively transferred the loss due to default to the CLN buyer but it loses future coupon income).
Thus, the CLN issuer's worst case scenario is that the credit sensitive bond actually performs well and doesn't downgrade or default because it is paying a higher coupon (sort of like paying the premium when buying a CDS) than it is receiving from the referenced bond and it only invested the cash in a Risk Free Asset (thus resulting in a return less than the risk free investment?)
If someone owned credit sensitive assets and wanted to reduce credit exposure, one could issue a CLN or buy CDS (pay insurance like premium but would also have counterparty risk). It seems that CDS has been the more popular alternative but perhaps CLNs may be a better if one actually considers counterparty risk from purchasing a CDS given that when a credit event is triggered? Especially if a downgrade is highly likely it would seem that a CLN would be a safer hedge (due to less counterparty exposure) but not sure what the market is like for buyers of CLNs (secondary markets, liquidity). Perhaps issuing a CLN is more costly and more difficult than buying a CDS (i.e. the higher coupon payment is more than the premium for CDS)?
Please correct me or add to this if anyone has any comments. Thanks.
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