We are receiving questions from market participants relating to the methodology and assumptions we apply when rating credit-linked note (CLN) transactions that reference credit derivative definitions and documentation (see "Criteria For Transactions Referencing Credit Derivative Definitions And Documentation," published Feb. 10, 2020). The responses to the questions below highlight some of the key rating considerations identified in our criteria. For context, many of the questions received relate to single-name CLNs. In instances where CLNs referencing a portfolio of corporate credit risk assets are issued, we will apply our corporate collateralized debt obligations (CDOs) criteria, alongside the abovementioned CLN criteria.

Frequently Asked Questions

What are credit-linked notes?

CLNs are fully-funded balance sheet instruments that provide the bondholder with a synthetic exposure to a reference entity/entities in a structure that resembles a synthetic corporate bond or loan. Credit risk can be transferred in return for coupon or premia payments.

What are the types of CLN transactions that you are seeing?

Typically, the proposals we have received and reviewed tend to be single-name CLN transactions issued by a financial institution. The CLN therefore is a direct obligation of the financial institution, which acts as the issuer of the CLN.

In addition, the transaction documents typically provide for the repayment of the CLN to be dependent on the credit risk of a given reference entity. The type of reference entity ranges from financial or non-financial corporates through to sovereign entities.

The issuer acts as protection buyer in the transaction, and the CLN investor(s) as protection seller, typically under a credit-default swap (CDS). Under the transaction terms, the issuer makes regular coupon or premia payments to the CLN investor. In return for such payments, the CLN investor(s) will make a protection payment to the issuer if there is a credit event.

In the proposals reviewed, any credit events incurred relating to the reference entity are typically governed by the 2014 ISDA Credit Derivative Definitions.

The credit events, obligation characteristics and category, deliverable obligation characteristics and category, and other key characteristics of the reference entity typically are aligned with those published in ISDA's credit derivatives physical settlement matrix, which sets out the terms applicable to each transaction type for the purposes of the 2014 ISDA Credit Derivative Definitions.

As a result, the likelihood of repayment of the CLN is a function of the credit risk of both the issuer and the underlying reference entity. Specifically, and as discussed further below, the rating on the CLN typically is linked to the lowest issuer credit rating (ICR) on the entities which the CLN has exposure to.

What are the general principles and assumptions that you apply when assessing CLN transactions that reference credit derivative definitions and documentation?

The rating on a typical CLN transaction is based on the following general principles as well as the transaction's structure and specific features of the reference entity and reference obligation.

Determining the rating on the issuer  Typically, the rating we would consider for the issuer would be its ICR. If there is no ICR but the issuer's obligations are guaranteed by a rated guarantor, then we may consider the rating on the guarantor in determining the rating on the issuer (see "Guarantee Criteria" referenced in the "Related Criteria" section).

Determining the rating on the reference entity  In general, our corporate, financial institution, insurance, and sovereign analysts assign ICRs to rated entities (either on a solicited or unsolicited basis). Alongside the ICR, we may also assign an issue rating for a specific debt issuance, which may differ from the ICR if, for example, it incorporates an assessment of relative seniority or ultimate recovery in the event of default.

The rating assigned to a single-name CLN would reflect the likelihood of default of the reference entity, and not its loss given default, which typically would be commensurate with its issue rating.

As a result, when reviewing single-name CLN proposals, the ICR on the reference entity--rather than its issue rating--would typically be considered for our analysis when determining the CLN rating. Notwithstanding any specific features relating to the transaction as we discuss further below, the CLN rating will therefore be determined based on a weak-link analysis, which considers the lowest ICR of the entities which the CLN has exposure to.

What does your rating review of a CLN transaction entail?

To date, all of our rating requests have been based on CLNs issued under a debt issuance program managed by the issuing financial institution. The program level terms and conditions are supplemented by a pricing supplement which further specifies the terms and conditions of each CLN trade with reference to the program level terms.

Most of our initial review process begins with reviewing the pricing supplement alongside the program level documentation to analyze the terms and conditions that apply to the CLN trade in question. This includes, but is not limited to, the following:

• All redemption events--including events which may result in a repayment shortfall for the CLN--which we would analyze together with our financial institution analysts (where necessary);
• All events of default;
• Issuer substitution conditions;
• Conditions for any further issuances of the CLN; and
• Any other events or conditions that may affect the CLN's performance.

It is also important to highlight that the formulation of CLN documentation appears to take two similar yet distinct approaches in relation to referencing the 2014 ISDA Credit Derivatives Definitions.

• The first comprises the program level documentation referencing the 2014 ISDA definitions; or
• The program level documentation substantively replicates the 2014 ISDA definitions, and these terms directly apply to the CLN transaction.

For the latter, one of the resulting effects is that the CLN would not be governed by any determinations made by the Credit Derivatives Determination Committee. In such instances our analysis has compared how credit events may be determined under the CLN versus what is outlined under the CLN criteria. At the same time, our analysis also focused on understanding which parts of the 2014 definitions are not included or differ in the program-level documentation.

Additionally, and when considering a portfolio of reference entities, any alternative process to the ISDA Determinations Committee in determining the recovery rate of the reference obligations may affect the expected loss amount of the underlying portfolio, especially when the protection buyer (i.e., the issuer) is the determination agent.

If a transaction has no 'obligation characteristics' specified in its documentation, how does this affect your rating assumptions for the reference entity under your weak-link analysis?

As highlighted above, part of our weak-link analysis includes determining the ICR on the reference entity, which overall determines the underlying credit risk and rating on the CLN. In making this determination, our analysis considers what would be the best proxy of payment likelihood/credit default risk for debt issued by the reference entity. In accordance with paragraph 31 of the CLN criteria, our starting point for this analysis would be the senior unsecured rating on the reference entity, which typically is the same as its ICR.

Are there any specific credit events which represent a risk factor in assigning a rating to a single-name CLN?

The application of obligation acceleration generally presents a risk factor in rating single-name CLNs.

In accordance with the physical settlement matrix, this credit event applies to transaction types such as standard Latin American corporate BL (and sovereign), standard emerging European corporate, and standard emerging European and middle eastern sovereign. As outlined under paragraph 47 of our CLN criteria, the difference in treatment of this credit event for a single-name CLN transaction is how the default timing may affect the CLN's performance. For example, a company may accelerate its debt obligation(s) due to a covenant violation.

Although an event such as a covenant violation may not necessarily constitute a default under our analysis, it may be deemed a credit event under obligation acceleration. In such a scenario, an investor in a single-name CLN would very likely lose money at that moment.

Finally, for sovereign reference entities, we understand that an obligation acceleration credit event may be determined under some documentation if a sovereign ceases to be a member of recognized organizations, such as the IMF, World Bank, and other similar entities. Like the above, these scenarios may not necessarily in themselves constitute a default of the sovereign under our analysis.

How would you address foreign exchange risk when the underlying reference obligation(s) is denominated in a different currency than the CLN?

Based on proposals received, we understand that foreign exchange risk may affect the CLN holder's overall loss amount as the recovery proceeds following a credit event of the reference entity may be denominated in a different currency than the currency of the CLN.

Our analysis for single-name CLNs would not typically consider foreign exchange risk as a risk factor to the transaction. As highlighted above, our analysis of single-name CLNs primarily focuses on the likelihood of default of the reference entity, rather than its loss given default, which factors in a recovery amount following a credit event.

By contrast, we would typically consider foreign exchange risk as part of our analysis when the CLN comprises a portfolio of reference entities. As outlined in the CLN criteria, this is because the recovery assumptions for any defaulted reference obligations would likely reflect any potential losses arising from currency conversion rates (see our foreign exchange risk criteria, referenced in the "Related Criteria" section below).

Related Criteria

• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Global Framework For Payment Structure And Cash Flow Analysis Of Structured Finance Securities, Dec. 22, 2020
• Criteria For Transactions Referencing Credit Derivative Definitions And Documentation, Feb. 10, 2020
• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019
• Foreign Exchange Risk In Structured Finance--Methodology And Assumptions, April 21, 2017
• Guarantee Criteria, Oct. 21, 2016
• Global Framework For Assessing Operational Risk In Structured Finance Transactions, Oct. 9, 2014
• Counterparty Risk In Terminating Transactions, Aug. 15, 2014
• Global Derivative Agreement Criteria, June 24, 2013
• Principles Of Credit Ratings, Feb. 16, 2011

Related Research

• Barclays Bank PLC Credit-Linked Notes Due 2024 Assigned Rating, Sept. 26, 2023
• S&P Global Ratings Definitions, June 9, 2023
• CDO Spotlight: What Is A Synthetic CDO?, April 30, 2010