What is a 'Credit Linked Note - CLN'

A credit linked note (CLN) is a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. CLNs are created through a special purpose company (SPC), or trust, which is collateralized with AAA-rated securities. Investors buy securities from a trust that pays a fixed or floating coupon during the life of the note.

BREAKING DOWN 'Credit Linked Note - CLN'

Based on the fact that CLNs are backed by specified loans, there is an innate risk of default associated with the security. In order to create a CLN, a loan must be issued to a customer. While an institution may choose to hold the loan, earning income based on interest payments received as the loan is repaid, or may sell the loan to another institution. In the latter option, loans are sold to an SPC or trust who ultimately divides the loan into various parts, often bundling similar parts together based on the overall risk or rating. The bundled parts are used to create securities which investors can purchase. At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate. The trust enters into a default swap with a deal arranger.

Credit Linked Notes as Investments

A CLN functions similarly to a bond in that payments are made semi-annually, but with a credit default swap attached. The SPC or trust pays the dealer par minus the recovery rate in exchange for an annual fee, which is passed on to the investors in the form of a higher yield on the notes. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk, and gives investors a higher yield on the note for accepting exposure to a specified credit event.

Default and Credit Linked Notes

The use of a credit default swap allows the risk associated with default to be sold to other parties and provides a function similar to insurance. Investors generally receive a higher rate of return than on other bonds as a compensation for the additional risk associated with the security.

In case of default, all involved parties including the SPC or trust, investors and, at times, the original lender are at risk for losses. The amount of loss experienced will vary depending on the number or loans, or parts of loans, are present in the security, how many of the associated loans end up in default, and how many investors are participating in the particular security packages.

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