What Is a Credit-Linked Note?

A credit-linked note (CLN) is a security with an embedded credit default swap permitting the issuer to shift specific credit risk to credit investors. Credit-linked notes are created 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 specified credit risks, investors who buy credit-linked notes typically earn a higher rate of return compared to other bonds.

Understanding Credit-Linked Notes (CLN)

Based on the fact that credit-linked notes are backed by specified loans, there is an innate risk of default associated with the security. To create a credit-linked note, a loan must be issued to a customer. Meanwhile, an institution may choose to hold the loan and earn income based on interest payments received as the loan is repaid, or it may sell the loan to another institution.

In the latter option, loans are sold to an SPV or trust, which 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 that 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 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.

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.

Special Considerations

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 compensation for the additional risk associated with the security.

In case of default, all involved parties including the SPV 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 of loans, or parts of loans, 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.