Tutorial: CREDEA bonds (Credit Linked Notes)


What is a CREDEA bond (credit-linked note)?

A CREDEA bond is a bond that hinges on a credit event. More specifically, the redemption, and also the coupon, depends on the occurrence of one credit event at one underlying referential debtors. The annual coupon is paid out as long as the referential debtor has not incurred a credit event. CREDEA bonds are also known as credit-linked notes (CLN).

What is a credit event?

Possible defined credit events are, depending on the terms of the bond, for example the insolvency of the referential debtor, default, premature call-ins of debt, disruptions to the servicing of debt, non-acknowledgement/moratorium, and restructuring.

How does a CREDEA bond (credit-linked note) work?

The investor buys a CREDEA bond and receives an attractive coupon throughout the life of the bond as long as no credit event occurs at the referential debtor. If a credit event occurs, the bond is redeemed prematurely. In that case the investor receives compensation in cash instead of the capital invested. Said compensation equals the market value of the respective referential debt. However, in this scenario investors will in all likelihood only receive a part of the principal back, or they may even incur a total loss (i.e. capital and interest).

The settlement of bonds where a credit event has occurred depends on the timeline of the credit event resolution process of the ISDA (Credit Derivatives Determination Committee) with regard to the referential debtor and the credit event.

What is the ISDA Credit Derivatives Determination Committee?
The ISDA was founded in 1985 and since then has been in charge of ensuring the safe and efficient settlement of over-the-counter (OTC)-traded derivatives. A derivative is a financial instrument whose value performance depends on an underlying instrument. The ISDA Credit Derivatives Determination Committee acts as independent and neutral party in determining the market value of a referential debtor upon the occurrence of a credit event. The redemption price of the CREDEA bond hinges on this determination. This means that the losses the investor incurs as a result of the credit event can depend to a large extent on the decisions of the Committee. The decisions of the ISDA can be accessed at www.isda.org/credit.

Your benefits

Due to the combination of various debtors (Erste Group Bank AG and the respective referential debtor) a CREDEA bond offers an attractive coupon. Redemption is at 100% at the end of maturity unless a credit event has occurred. This means that if the referential debtor honours its debt service as expected, the CLN is redeemed at the end of maturity at its nominal value. Among other things, CREDEA bonds are used to diversify the portfolio

Your advantages

  • Attractive coupon
  • As a result of the combination of numerous debtors, CREDEA bonds offer a higher coupon than the individual bonds of the respective debtors.
  • Redemption at 100% of nominal value at the end of maturity if no credit event has occurred at the referential debtor

Risks you should be aware of

  • Default risk of the referential debtor(s)
  • The coupons are only paid and the capital is only redeemed at the end of maturity if no credit event has taken place.
  • In case of a credit event, the bond is redeemed prematurely, and you may incur losses up to 100%.
  • There is no capital guarantee.

How do CREDEA bonds (credit-linked notes) react to...

... interest rates rise?
The price of fixed-rate CREDEA bonds falls when interest rates are rising. This means that you may incur losses in case of selling prior to the end of maturity. On the other hand, CREDEA bonds with variable coupons benefit from rising interest rates. Given that the coupon is regularly adjusted to a referential interest rate (e.g. the EURIBOR), the coupon rises alongside the level of interest rates. The price tends to stay around 100%.

... stable interest rates?
If the general interest rate level remains unchanged, neither the price nor the coupon of CREDEA bonds changes ceteris paribus.

... falling interest rates?
The price of fixed-rate CREDEA bonds rises when interest rates are falling. This means that you may record a profit in case of selling prior to the end of maturity. On the other hand, rising interest rates affect CREDEA bonds with variable coupons negatively. Given that the coupon is regularly adjusted to a referential interest rate (e.g. the EURIBOR), the coupon falls alongside the level of interest rates. The price tends to stay around 100%

... rising credit risk?
If the credit risk of the referential debtor rises, the price of a CREDEA bond falls, given that the probability of the occurrence of a credit event increases.

... unchanging credit risk?
If the credit risk of the referential debtor remains unchanged, so does the price of the bond (ceteris paribus).

... sinking credit risk?
If the credit risk of the referential debtor falls, the price of a CREDEA bond rises, given that the probability of the occurrence of a credit event decreases.