Credit-Linked Notes Nick Johal Thursday 4 th June 2015

Agenda  Investing in Credit for DFMs – issues and challenges  What are the benefits of taking a synthetic credit exposure?  What are the risks?  Questions & Appendix 2

Investing in Credit – Issues DFMs face  Prospectus Directive  Duration  Liquidity  Supply  Retail Bonds  Absolute Return/Strategic Bond Funds 3

Tailwinds for Credit  Demographics  Annuities changes and NISA  Benign inflation environment  Japanification of Europe  Technicals 4

What are the benefits of taking a synthetic credit exposure? 5

Credit Linked Note (CLN) 6 A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors.credit derivativesecurity credit default swap Synthetically, the risk profile is similar to being ‘long’ the reference entity. On the Issue date, the investor buys the CLN at par value. As a note holder, he is entitled to receive the coupons linked to the credit risk of the underlying. At maturity;  If no Credit Event has occurred since inception, the Notes are redeemed at par value on the maturity date.  If a Credit Event has occurred since inception, the Notes are redeemed by paying the Recovery Value to the note holder. The investor bears a loss of {(1-R)*N]. In a worst case scenario, investors could lose their entire investment. Various iterations are possible e.g. Single name CLN – The note is issued with protection sold on one reference entity Basket CLN – The note is issued with protection sold on a basket of defined reference entities. First-To-Default baskets

Credit Linked Note (CLN) – simple cashflows 7 InvestorBankCDS Market Treasury desk 100 CLN CDS Spread 100 Funding Ref Entity

Transparent and easy to price 8 CLN coupon = CDS spread + Swap rate + funding - cost *priced 18/11/2014 SKYLN8y CLN Coll 8y £ Swap rate (IRSB)2.00 CDS Spread (CDX/CDSW)1.00 Funding0.05 Cost-0.10 CLN coupon (%)2.95

Liquid, Flexible, Access 9 Credit Duration Denomination Coupon Type Currency Priced at Par Positive Basis Costs vs Funds Curves CDS Liquidity QCB Economic Benefit Flexibility Access

Supply no longer an issue 10

(CL01) 10y MKS fixed-floating CLN 11 IssuerSG Issuer CurrencyGBP Maturity10y Issue Price100% Coupons/a RecoveryMarket SettlementAmerican 3.8% pa years 1 & 2 6m£L + 125bps thereafter, paid UTD

Short Duration European HY 12 Itraxx Europe Xover S23 IssuerSG Issuer CurrencyGBP Maturitylong 5y Issue Price100% Coupons/a 0% Coupon = 6m£L+3.8%*n/75 n = number of Ref Entities for which no Credit Event has occurred. Redemption = Par if no credit events Redemption = 100%-N/75 where N is the number of Credit Events

What are the risks? 13

Risks & Mitigants 14  MTM/Basis risk  Issuer risk  Liquidity  Transparency  Quanto  Collateral (for secured issues)

Questions & Appendix 15

Credit Derivatives - CDS basics 16 Can be Cash or physically settled. If physically settled, additional complexity of CTD bond.

CDS – Credit Event 17 The Credit Risk of a Reference Entity (corporate or government) can be thought of as the risk that it will experience a Credit Event over a predefined time horizon. Definition of a Credit Event 1.Bankruptcy 2.Failure to pay 3.Restructuring (not applicable to US entities) 4.Repudiation & Moratorium (only for Sovereign entities) The definition of a Credit Event is standardised across all counterparties in the credit market as per the terms defined by International Swaps and Derivatives Association (ISDA)

Credit Indices 18 Offer Liquidity, Tradability and Transparency Index components are selected by the Index sponsor based on specific criteria: liquidity, trading volumes, rating, etc. The rolls occur every six months for standardised contracts.  iTraxx Main Europe125 European IG corporates  iTraxx Xover (Europe)75 most liquid sub IG European names  CDX North America125 North American IG corporates

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