Unfunded credit risk

There are two types of CDO liability structures utilized in synthetic transactions completely unfunded structures that use portfolio swaps exclusively to transfer the entire credit risk of the reference portfolio to investors and partially funded structures which transfer only the highest credit risk segment of the portfolio. 

A much easier method of generating leverage in a credit portfolio is through credit default swaps (CDS). They let investors take on or lay off default risk in an unfunded manner. Selling default protection enables one to receive the premium associated with the additional credit risk without the need to buy a bond of that entity, and in the process creates enormous leverage, especially for higher rated credits. The increased liquidity and the compression of bid/offer spreads have added to the attractiveness of this market. 

Credit-linked notes, or CLNs, are known as funded credit derivatives, because the protection seller pays the entire notional value of the contract up front. In contrast, credit default swaps pay only in case of default and are therefore referred to as unfunded. CLNs are often used by borrowers to hedge against credit risk and by investors to enhance their holdings yields. 

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