A credit derivative is a tool designed to transfer credit risk between two parties: a credit risk seller and a credit risk buyer. The former is interested in transferring the credit risk to another party in exchange for a premium (price of protection/ risk offload), while the latter is interested in receiving a premium for the protection against credit risk (inability of a debtor to fulfill contractual obligations). The credit risk buyer takes the credit risk instead of the seller according to specific conditions and for a specific period of time.

In funded credit derivatives, the protection seller, i.e., the party that bears the credit risk, makes an initial payment that will be used to settle any potential credit events. This helps reduce or limit the counterparty risk faced by the protection buyer. The contract is usually entered into by a financial institution and a special purpose vehicle (SPV) so that payments are funded using securitization means. The obligations are supported by issuing a debt obligation by either party.

The main funded credit derivatives include credit-linked notes (CLNs), collateralized debt obligations (CDOs), constant proportion debt obligations (CPDOs), and principal protected products.

• Credit-linked notes (CLNs): s structured note in which a credit derivative such as a CDS, is embedded. The purchase of a CLN bears the credit risk of the reference credit and an underlying collateral (some high-quality asset). In practice, a special purpose vehicle issues a CLN based on a reference entity’s credit risk. If the entity defaults, the note will no more be redeemable at par (100% of value), but the holders will receive below par percentage such as 70%.
• Collateralized debt obligations (CDOs): a structured product in which an SPV issues bonds/ notes against the cash flows of an underlying pool of assets (bonds, loans, etc).
• Constant proportion debt obligations (CPDOs): a variant of constant proportion portfolio insurance (CPPI) which only provides a leverage exposure to credit portfolios (without principal protection). A CPDO pays a fixed coupon with no upside potential and rebalances the portfolio between risky credit assets and a safe asset.
• Principal protected products: coupon-paying financial products that guarantee the return of an investment at the maturity date of the structure, irrespective of the performance of the underlying reference assets. Payment of the coupons will cease in the event of the reference entity.