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CREDIT LINKED NOTE
A credit-linked note is a security issued by a special purpose company or trust, designed to offer investors par value at maturity unless a referenced credit defaults. In the case of default, the investors receive a recovery rate.
The trust will also have entered into a default swap with a dealer. In case of default, the trust will pay 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 their note.
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 CLNs themselves are typically backed by very highly-rated collateral, such as U.S. Treasury securities.
The Italian dairy products giant, Parmalat, notoriously dressed up its books by creating a credit-linked note for itself, betting on its own credit worthiness.
CLN is a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors.
CLNs are created through a Special Purpose Company (SPC), or trust, which is collateralized with AAA-rated securities. Investors buy securities from a trust that pays a fixed or floating coupon during the life of the note. 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. In case of default, the 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.
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.
See also
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