Credit Sensitive Notes
In a conventional bond or note, the interest rate (or coupon) is decided at the time of the contract and it remains the same for the entire duration of the contract. Ofcourse, in certain products such as Step-up and Step-down notes the interest rate changes with time. Nonetheless, in both the cases, the rate of interest is decided at the time of the contract depending on various factors, including and most importantly on the credit standing of the borrower. However, the credit standing is not a static feature or variable. It changes over time. The interest rate in a traditional note or bond does not change with changes in this credit standing; it is fixed at the time of issue and remains fixed irrespective of the changes in the credit standing.
A Credit Sensitive Note is an instrument (a medium term note) which addresses this issue. Its interest rate is linked to the credit rating of the firm in such a manner that if the credit ratings of the borrower increase, the interest rate (or coupon) of the note decreases and vice-versa. The following is an example of how this works.
Let's suppose Company ABC, a AAA rated company, issues a Credit Sensitive Note on 1st Jan 2021 having a duration of 5 years with a fixed interest rate of 7% payable annually. The note is linked to its credit rating in the below manner. The interest reset to credit rating is done once every year.
Let's further suppose that in the beginning of 2022, the credit rating of ABC deteriorates to A. As per the above table, the interest rate of the note will now increase by 125 bps, the new interest rate payable for 2022 would be 8.25%. If in 2023, the credit rating improves to "AA", the interest rate of the note will now decrease to 100bps, the new interest rate payment will be 8%. Therefore, in this way, the interest rate payable will change depending on the changes in credit rating.
These sort of notes are not usually issued to public. They are generally privately placed with institutions, and are classified as Structured Products. They are also commonly known as "Rating Sensitive Notes". These notes are very different from a similar named product called 'Credit Linked Notes', which have a CDS embedded into it. A credit sensitive notes is not linked to a default of the borrower, it is only linked to the credit ratings of the borrower. These notes are also different from floating rate notes, whose interest rates are linked to market interest rates.
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