Credit Linked Notes – High Coupon for taking downside risk on index

Last week I wrote about how one might construct a Principal Protected Put (“PPP”) (thank you PW) to buy protection for a downside move in a home price index, at the cost of foregoing income.  Today, I’d like to highlight the opposite strategy, where one might accrue a higher coupon, at the expense of taking exposure to downside movements in a home price index.  A hypothetical example of the possible resulting payouts (referencing the SFRX20 contract) is shown below.

At a high level, if an investor bought such a CLN, and  if the SFR index was above 270 at expiration in Nov. 2020, the investor would receive 100% of principal back, while earning a coupon that paid 1.3% over a benchmark rate (e.g. Libor in the past).   However if the SFR index was below 270 at expiration (only) then the amount of principal paid back at maturity would decline (as show in the second column from the left).

Further, if an investor preferred a higher coupon, the put could be internally leveraged (in the example to the right) such that the coupon was three times as high, but at the expense of the principal reduction also being 3x as fast, should the SFR index be below 270 at maturity.

Note for this example that the SFR spot index is 268.34, but the SFRX20 contract closed at 285.0.  I’ve picked a 270 strike for the puts as it’s close to the SFR spot level, but >5% out-of-the-money on the SFRX20 contract.  (Many credit note investors prefer a base case -in this instance where the current futures contract price remaining unchanged- where full coupon and principal would be returned at maturity.)   I’ve rounded off the term to 2 years (i.e. as if today were Nov. 30, 2018) to simplify math, and assumed no expenses, or margin calls, all of which are realities that would need to be addressed.   As with the PPP concept, any combination of expiration, and strike is theoretically possible, for any region, with a range of leverage.  Finally, all of the above analysis is predicated on being able to find a party willing to buy the put (from the CLN issuer).  (To save you the math, I’ve assumed a market of 7.0/11.0 for the CME SFRX20 270 puts and that the CLN issuer sells the puts at 7.0).

Again, the point of this example is not to tout or create an actual CLN, but to illustrate the moving parts behind one, and to show a “short put” strategy in a bond-like comparison.

MBS credit investors should be very familiar with the concept as it generally mirrors the structure of the billions of  STACR/CAS bonds that Freddie Mac and FNMA have issued over the last few years.  In fact, I’d argue that such a CLN might be much easier to trade as: a) the underlying reference obligation is publicly traded -so price discovery and hedging is possible, b) the term is only two years (in this example), and c) severity on CLN is known upfront )).  Such a CLN/ index put/ strategy concentrates “credit” exposure to one region, while STACR/CAS bond investors have tail exposure to whatever the weakest MBS credit areas might evolve to be over the much longer lives of those deals.

Please feel free to contact me ( if you’d care to discuss this blog, options on home price indices, or any other aspect of hedging home price indices.

Thanks,   John




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