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Credit-linked comes of age

How can an investor get exposure to below investment-grade risk while investingin AAA rated bonds? Credit-linked notesprovide an answer, but does anyone really know how to price them? By James Rutter.

In a 1994 conference presentation, David Marks, head of MTNs at JP Morgan, identified credit-linked notes as the MTN market's next big product. Four years and a fair few conferences later, it appears his prediction is finally coming true. "Every week we're getting more borrowers interested," he says. As if on cue, a credit-derivatives trader appears at his shoulder to show him an idea.

A credit-linked note is usually a bond incorporating a default swap on a credit other than that of the issuer. For example, a triple A borrower can issue a note that will redeem at a predetermined sum if the Republic of Brazil defaults on any of its debt obligations. In return for taking this risk the investor will receive higher-than-normal coupon payments.

Marks is not alone in seeing 1998 as a watershed year for credit-linked notes. "They're here," says Mark Ames, head of MTNs at Lehman Brothers. "I don't think there can be any debate about it." There may be no debating the figures (issuance for the first quarter was 10 times higher than 1997, according to CapitalNet MTNWare) but for the vast majority of issuers there is still far more talk than action.

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