Credit-Linked Notes (CLN) are structured securities whose principal and interest payments are contingent on the performance of specified borrower companies, or Reference Entities. They are created by embedding a Credit Default Swap (CDS) in a funded asset to form an investment whose credit risk and cash flow characteristics resemble those of a bond or loan.

CLN Permit Cash Investors to Access the Credit Default Swaps Market

CLN are generally purchased by investors who are attracted to the investment benefits of Credit Default Swaps, but who do not transact in swaps directly due to credit, operational, legal or investment policy constraints. These benefits include:

• CDS may offer investors higher returns for assuming very similar credit risk, e.g. as an alternative to a direct bond investment. CDS can present new opportunities to relative-value investors.
• CDS may offer access to hard-to-find credit risk, e.g. access to credits for which there is a limited supply of bonds or where the borrower deals primarily with a small syndicate of bank lenders and have no public bonds outstanding.
• CDS may enable investors to take on international credits without bearing unwanted currency risk.
• Investors can use CDS to tailor credit exposures to match their precise requirements with respect to maturity as well as seniority in a company's capital structure.
• Canadians restricted from investing in foreign securities may be able to take exposure to foreign credits through CLN's due to the derivative format of the credit component and domestic status of the collateral and named issuer.

Choice of Credit-Linked Note Issuer

BMO can issue CLN in one of two ways:

• in Bank of Montreal's name in various forms of deposit notes, depending on term and other requirements; or,
• from a BMO-sponsored special purpose vehicle (SPV) in the form of private placement notes.

Both produce the same essential cash flows and consequences should the Reference Entity experience a credit event. In both arrangements BMO is the CDS counterparty.

Diagram: BMO Credit-Linked Note

Diagram: BMO Sponsored SPV Credit-Linked Note

Just Another Bond

CLN are purposefully structured to allow conventional bond systems to easily accommodate their purchase and valuation:

Documentation: BMO-issued CLN are issued under standard bank deposit note documentation, while SPV-issued CLN are issued pursuant to a standard Trust Offering Memorandum.

Credit Event Settlement Options

Should the CDS Reference Entity in a CLN experience a credit event, the CLN will mature early. What the CLN investor receives under these circumstances depends whether the CDS is contracted for physical or cash settlement. Which one depends on the preference of the investor at the time the CLN is structured. Physical settlement results in the CLN investor receiving a debt obligation of the CDS Reference Entity (in a face amount equal to the CDS notional principal) in lieu of return of principal. Cash settlement results in the CLN investor receiving the market value of a debt obligation of the CDS Reference Entity (in a face amount equal to the CDS notional principal) in lieu of return of principal.

Investment Considerations

Canadian investors may be constrained by the fact that the Credit Default Swaps market references mostly U.S. and European credits, and trades in U.S. dollar and Euro notional amounts. However, well traded international credits are also quoted efficiently in Canadian dollars, and there are an increasing number of Canadian credits on which CDS are being traded, which will interest conventional bond investors looking for alternative credit investments.