Credit-Linked Note (CLN)

A credit-linked note (CLN) is a debt security that combines an ordinary note with credit protection on a third party, called the reference entity. The investor pays the full principal up front and receives a coupon that is higher than the issuer's normal funding rate. If the reference entity suffers a defined credit event, such as bankruptcy or failure to pay, the note is redeemed early at a reduced amount that reflects the reference entity's recovery value. Banks, hedge funds, insurers and private banking clients use CLNs.

A CLN is in effect a funded version of a credit default swap (CDS). In a CDS the protection seller pays only if a default happens; in a CLN the protection seller (the investor) has already handed over the cash, so the buyer of protection does not face the seller's counterparty risk. CLNs are issued by banks directly or through a special purpose vehicle (SPV), and credit events are usually defined by reference to the ISDA Credit Derivatives Definitions.

Imagine a friend asks you to cover the risk that a mutual acquaintance will not repay a loan. Instead of promising to pay later if things go wrong, you hand your friend the money now and they keep it safe. Each year they pay you a bit extra for taking the risk. If the acquaintance repays, you get your money back at the end. If the acquaintance defaults, your friend keeps the part needed to cover the loss and returns what is left.

That is how a credit-linked note works. The investor lends money to the issuer and earns extra interest for carrying someone else's credit risk. Because the cash is already in hand, the issuer never has to chase the investor for payment.

The issuer, often an investment bank, sells the note and buys protection from the investor through an embedded credit derivative. When an SPV is used, it invests the proceeds in high-quality collateral, such as government bonds, and sells protection to a bank through a CDS; the collateral backs the notes. Over the note's life, the investor's coupon is roughly:

• $r_{\text{ref}}$ is the reference rate, for example SOFR on a floating-rate note.
• $s_{\text{CDS}}$ is the CDS premium on the reference entity, the payment for bearing its credit risk.
• $s_{\text{issuer}}$ is the issuer's own funding spread (close to zero for a well-collateralised SPV).

If a credit event occurs, the note stops paying interest and redeems early. For a single-name CLN the investor typically receives:

where $N$ is the note's principal and $R$ is the recovery rate on the reference entity's debt, often fixed in an ISDA auction. The investor's loss is $N \times (1 - R)$, linked to the reference entity's loss given default.

Worked example: an investor buys a five-year CLN of 10 million referencing a company whose CDS trades at 2.5%. With a floating rate of 4.0% and an issuer spread of 0.3%, the coupon is about 4.0 + 2.5 + 0.3 = 6.8% a year, or 680,000. Shortly after the second coupon, in year three, the reference company files for bankruptcy and the auction sets recovery at 35%. The note redeems at 10 million × 0.35 = 3.5 million, a principal loss of 6.5 million, offset in part by the 1.36 million of coupons received over the first two years.

The 2014 ISDA Credit Derivatives Definitions list the standard credit events, chosen by type of reference entity:

• Bankruptcy. Insolvency, liquidation or similar proceedings for corporate references.
• Failure to pay. Missing a payment above a threshold after any grace period.
• Restructuring. A binding debt restructuring that worsens terms for creditors, with several regional variants.
• Repudiation or moratorium, and obligation acceleration. Used mainly for sovereign and emerging-market references, where a sovereign default is the main concern.
• Governmental intervention. Added in 2014 for financial institution references, covering bail-in style actions.

Beyond single-name notes, CLNs can reference a basket of names (first-to-default or proportional loss) or a tranche of a portfolio, which links them to collateralized debt obligations and synthetic securitization.

Banks issue CLNs to transfer the credit risk of loan portfolios to investors without selling the loans, a practice called synthetic risk transfer. If the structure meets supervisors' requirements, the bank can hold less bank capital against the protected loans under Basel III, and the funded format avoids counterparty exposure to the investor. Investors use CLNs to gain exposure to credits they cannot easily buy directly, such as loans or emerging-market debt, or to get credit exposure in a note format their mandate allows.

A CLN investor is exposed to two credits: the reference entity and, unless the note is issued by a ring-fenced SPV, the issuer itself. If the issuer fails, the investor may lose money even if the reference entity is fine. Collateral quality matters for SPV notes, as the 2008 financial crisis showed when some vehicles held assets that lost value. CLNs are usually illiquid, complex to value and sensitive to legal disputes over whether a credit event has occurred. The embedded derivative is not closely related to the host note, so issuers and many holders account for it at fair value.

• International Swaps and Derivatives Association (ISDA)
• Bank for International Settlements