Understanding Credit-Linked Notes: How CLNs Manage Credit Risk

A credit-linked note (CLN) serves as a financial instrument that allows issuers to shift specific credit risks using an embedded credit default swap. Typically structured through a special purpose vehicle (SPV) or trust, these notes are collateralized with AAA-rated securities, offering investors potentially higher returns compared to traditional bonds. CLNs function similarly to bonds, where investors purchase them in exchange for fixed or floating coupon payments, accepting specified credit risks in return.

Credit-linked notes have a risk of default because they are backed by specific loans. Creating a credit-linked note starts with issuing a loan to a customer. An institution can hold the loan to earn interest or sell it to another institution.

If sold, loans go to an SPV or trust, which divides and bundles them by risk or rating. These bundles create securities for investors to buy.

At maturity, investors get par value unless the credit defaults, then they receive the recovery rate. The trust enters into a default swap with a deal arranger.

A credit-linked note functions similarly to a bond in that payments are made semi-annually, but with a credit default swap attached. The SPV 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. It gives borrowers a credit risk hedge and provides investors a higher yield for accepting credit event credit event risk.

• Credit-linked notes (CLNs) are financial instruments that allow issuers to transfer specific credit risks to investors via an embedded credit default swap.
• CLNs are typically created through a special purpose vehicle (SPV) that is collateralized with AAA-rated securities and sold to investors seeking higher yields.
• Investors in CLNs accept exposure to specified credit risks in exchange for potentially higher returns compared to traditional bonds.
• If a referenced credit event occurs, investors might face losses based on the recovery rate rather than receiving the full par value at maturity.
• The structure of CLNs serves both as a hedge against credit risk for issuers and as an opportunity for investors to earn higher yields for taking on additional risk.