Credit-linked note

A Credit Linked Note (CLN) is a structured product typically issued by a financial institution, such as banks or SPV. It is structured as a financial instrument that combines a bond and a credit derivative, the bond represents the equivalent of the funding leg, that is how much the bank pays for an investor to borrow money from it, and the credit derivative the risk overlay. The core function of a CLN is to transfer a specific credit risk, knows as reference entity, from the issuer to the investor. In return for taking this credit risk, the investor receive an enhanced yield, or higher coupons compared to a vanilla bond with a similar maturity.

The note's cash flows are contingent upon the absence of a credit event related to the reference entity. On most of CLN's, a credit event is strictly defined by the ISDA definitions, which are incorporated into the CLN's legal documentation. Standard ISDA credit events include Failure to Pay, Bankruptcy, and Restructuring of the reference entity. If no credit event occurs during the life of the note, the investor receives periodic coupon payments and the full return of principal at maturity. If a defined credit event occurs, the note is terminated, and the investor suffers a loss on the principal, in that case the investors receive a recovery rate. Recovery can also be fixed, most of the time at 0% as investors looking for yield, market recovery are also priced, and for investors looking for safer investments, principal can be non-risky to reference entity, only coupons will remain risky.

The purpose of the arrangement is to pass the risk of specific default onto investors willing to bear that risk in return for the higher yield it makes available.

The performance of a CLN is subject to two main risks: the credit risk of the reference entity and the counterparty risk of the issuer itself.