Credit-Linked Note (CLN)
What Is a Credit-Linked Note?
A credit-linked note (CLN) is a security with an embedded credit default swap allowing the issuer to shift specific credit risk to credit investors. Credit-linked notes are made through a special purpose vehicle (SPV), or trust, which is collateralized with AAA-rated securities. Investors buy credit-linked notes from a trust that pays a fixed or floating coupon during the life of the note. In return for accepting exposure to determined credit risks, investors who buy credit-linked notes normally earn a higher rate of return compared to different bonds.
Understanding Credit-Linked Notes (CLN)
In light of the way that credit-linked notes are backed by determined loans, there is a natural risk of default associated with the security. To make a credit-linked note, a loan must be issued to a customer. In the mean time, an institution might decide to hold the loan and earn pay in light of interest payments received as the loan is reimbursed, or it might sell the loan to another institution.
In the last option, loans are sold to a SPV or trust, which eventually separates the loan into different parts, frequently bundling comparable parts together in view of the overall risk or rating. The packaged parts are utilized to make securities that investors can purchase.
At maturity, the investors receive par except if the referenced credit defaults or declares bankruptcy, in which case they receive an amount equivalent to the recovery rate. The trust goes into a default swap with a deal arranger.
Credit-Linked Notes as Investments
A credit-linked note functions in much the same way to a bond in that payments are made semi-annually, however with a credit default swap joined. The SPV or trust pays the dealer par minus the recovery rate in exchange for an annual fee, which is given to the investors as 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 predefined credit event.
Special Considerations
The utilization of a credit default swap permits the risk associated with default to be sold to different parties and gives a function like insurance. Investors generally receive a higher rate of return than on different bonds as compensation for the extra risk associated with the security.
In case of default, all elaborate parties including the SPV or trust, investors and, now and again, the original lender are at risk for losses. The amount of loss experienced will change contingent upon the number of loans, or parts of loans, present in the security, the number of the associated loans end up in default, and the number of investors that are participating in the particular security bundles.
Features
- Issuers of credit-linked notes use them to hedge against the risk of a specific credit event that could make them lose money, for example, when a borrower defaults on a loan.
- Investors who buy credit-linked notes generally earn a higher yield on the note in return for accepting exposure to determined credit risks.
- A credit-linked note (CLN) is a financial instrument that permits the issuer to transfer specific credit risks to credit investors.
- A credit default swap is a financial derivative or contract that permits issuers of credit-linked notes to shift or "swap" their credit risk to another investor.
