Residual values of credit linked notes

A few investors still do not understand why the residual values of the Mini bonds are better than the Pinnacle Notes, Jubilee Notes and High Notes 5. It is important that they put in the effort to understand what they have bought and why it has dropped in value. They should not continue to be ignorant.

Here are the differences in structure of these notes.

Mini bonds. They carry credit default swaps on a number of entities. None of these entities failed, so there in no call on the swaps. The underlying asset is still intact. The problem is that the issuer Lehman Brothers has gone into insolvency. The trustees appointed a firm to handle the liquidation of the underlying assets and pay the residual value to the investors. These values range from 23% to 75%, depending on the tranche.

High Notes 5 and Jubilee Notes. These notes carry credit default swaps on a number of entities. One entity is Lehman Brothers. When this entity went into insolvency, the swap was called and the total invested amount was taken away to pay the counter-party to the swap. There is no residual value in these notes.

Pinnacle Notes. These notes carry credit default swaps on a large number of entities. If a specified number of entities (say 13 out of 200 entities) go into default, the total invested sum is used to pay out to the counter party to the swap. A few tranches have reached this critical number and the value of these tranches is almost nil. Some tranches are approaching this number, and the value is now quite low, say less than 20%. The investors can only hope that there are no more credit events, to get back their original investment. The alternative, is to sell them at the current market value.

Sell at market value?
Should the investor sell the notes at the current market value? If I were an investor, I would hold on to the notes as the current market value is likely to be lower than the underlying value (whatever the value is). The market maker probably knows the underlying value, and will offer a value that represents a deep discount. However, each investor should make his or her own decision on this matter.

Tan Kin Lian