Credit-Linked Note (CLN)

A credit-linked note (CLN) is a structured debt instrument that combines a regular bond-like security with an embedded credit default swap (CDS). It lets an issuer transfer specific credit risk—typically the risk that a particular borrower or reference entity defaults—to investors in exchange for a higher yield.

How a CLN is created

• An originator (e.g., a bank) groups loans or exposures and transfers them to a special purpose vehicle (SPV) or trust.
• The SPV collateralizes the transaction (often with high-quality securities) and issues notes to investors.
• The SPV enters into a credit default swap with a protection seller (or deal arranger). That CDS links the note’s payoff to the credit performance of one or more reference entities.
• Investors buy the notes and receive coupon payments during the life of the CLN. At maturity they receive par unless a credit event occurs for the referenced entity, in which case they receive the recovery value instead of full principal.

Key features

• Embedded credit default swap: moves specified default risk from issuer to investors.
• Coupon: typically higher than comparable plain-vanilla bonds to compensate for credit exposure.
• Reference asset(s): the performance of one or more specified borrowers determines potential losses.
• SPV structure: isolates assets and liabilities and facilitates the transfer of credit risk.
• Recovery rate: if a referenced borrower defaults, payout is reduced according to the expected recovery rate.

How CLNs work for issuers and investors

• Issuers (or originators) use CLNs to hedge or offload the credit risk of specific loans or borrowers without selling the underlying loan outright.
• Investors accept exposure to the specified credit risk in return for higher yields than similar-rated conventional bonds.
• Payments are typically periodic (e.g., semiannual coupon payments) and final principal depends on whether a credit event occurs.

Risks and considerations

• Credit risk: investors bear direct exposure to the creditworthiness of the reference entity(ies). Losses depend on defaults and realized recovery rates.
• Counterparty risk: the effectiveness of the embedded CDS depends on the creditworthiness of the protection seller and the SPV’s structure.
• Complexity: CLNs can reference single or multiple entities, include layered tranches, or have bespoke triggers—understanding contract terms is essential.
• Liquidity: secondary markets for CLNs can be limited compared with standard corporate bonds.
• Concentration risk: a CLN tied to a single reference entity concentrates exposure; multi-name CLNs (e.g., baskets or CDO-like structures) introduce correlation risk.
• Legal/operational risk: resolution of credit events and recovery calculations can be complex and may involve litigation or protracted processes.

Who uses CLNs

• Banks and other lenders seeking to hedge or repackage loan exposures.
• Institutional investors or credit-focused investors seeking enhanced yield and willing to accept specific credit exposures.
• Structured-product investors looking for customized risk-reward profiles.

Simple example

A bank wants to reduce exposure to Company X. It places the loan in an SPV, which issues a CLN referencing Company X. Investors buy the CLN and receive higher coupon payments. If Company X performs, investors receive full principal at maturity. If Company X defaults, investors receive principal reduced to the recovery value determined under the CDS terms.

Bottom line

A credit-linked note transfers specified credit risk from an issuer to investors via an embedded credit default swap and an SPV structure. CLNs can offer higher yields but carry concentrated, often complex, credit and counterparty risks. Prospective investors should review the reference obligations, contract triggers, recovery mechanics, and counterparty strength before investing.