What is a credit-linked note (CLN)?
A credit-linked note is a debt security that combines a regular bond-like payoff with a credit derivative (usually a credit default swap, or CDS). The CDS component transfers the credit risk of one or more reference obligors (borrowers) from an arranger to investors in the note. Investors receive periodic coupon payments in exchange for taking on the risk that the referenced borrower(s) will default. If a specified credit event happens, investors may lose part or all of the note’s principal, depending on the recovery rate (the percentage of value recovered after default).
Key definitions (first use)
– Credit default swap (CDS): a contract that provides protection against a borrower’s default; the buyer of protection receives compensation if a defined credit event occurs.
– Special purpose vehicle (SPV): a separate legal entity created to hold assets (often to insulate the originator from those assets’ risks) and to issue securities backed by those assets.
– Coupon: the periodic interest payment made to holders of a note or bond.
– Par (face value): the nominal principal amount of a security, typically the amount repaid at maturity absent default.
– Recovery rate: percentage of par an investor receives if the referenced borrower defaults.
How a CLN is structured (step‑by‑step)
1. Origination: A lender originates loans or acquires loan assets.
2. Transfer to SPV/trust: The lender sells the referenced loan(s) to an SPV or trust, which holds high‑quality collateral (often highly rated securities) to secure the obligation.
3. Creation of the CDS link: The SPV arranges a credit default swap or similar contract that references the borrower(s). The SPV pays a fee to receive protection or to transfer default risk.
4. Issuance: The SPV issues the credit-linked notes to investors. The notes pay a fixed or floating coupon during their term.
5. Cash flows in life: Investors receive coupon payments. The SPV manages collateral and pays any fees to counterparties.
6. Maturity/default: If no credit event occurs, investors receive par at maturity. If a reference credit defaults, investors receive a settlement amount linked to the recovery rate (often par minus the loss) instead of full par.
Why issuers and investors use CLNs
– Issuers (or originators) can move specific loan credit risk off their balance sheet while financing at competitive rates.
– Investors receive a higher coupon than a comparable plain‑vanilla bond because they accept extra credit exposure. The CDS-like feature is effectively selling protection to the arranger.
Main risks and special considerations
– Credit risk: If one or more referenced borrowers default, investors can lose principal. Loss equals (1 − recovery rate) × par for the defaulted exposure.
– Counterparty risk: The CDS counterparty or other counterparties may fail to meet obligations.
– Liquidity risk: CLNs can be less liquid than standard bonds; secondary market trading may be limited.
– Complexity and transparency: Structures may bundle many loans and tranche them; understanding which credits back the note and the exact default triggers is essential.
– Collateral and SPV quality: The SPV’s assets and legal structure affect how well losses are isolated and whether investors can rely on promised cash flows.
– Regulatory or accounting treatment: These differ by jurisdiction and institutional status.
Short checklist before considering a CLN (educational checklist — not investment advice)
– Identify the reference asset(s): single name or basket? Corporate loans, sovereigns, or other?
– Confirm the credit event definition and recovery method in the documentation.
– Check whether principal is conditional on no default (i.e., not principal protected).
– Review the SPV’s collateral, ratings, and legal setup.
– Assess counterparty exposure for the embedded CDS and dealer/arranger.
– Compare coupon/yield relative to similar-duration plain bonds and ask whether the extra yield compensates for credit and liquidity risk.
– Review liquidity (secondary market) and historical trading volumes.
– Read the prospect