CLNS

Credit-linked notes (CLNs) are a class of structured debt instruments designed to transfer credit risk from the issuer to the investor. They are typically issued by banks or other financial institutions and often offer higher yields than standard bonds in exchange for bearing the credit risk of one or more reference entities. The payoff profile of a CLN is linked to the creditworthiness of the designated reference entity and to defined credit events.

The structure combines features of a debt obligation and a credit default swap (CDS). If no credit event occurs during the term, the investor receives periodic coupons and the principal at maturity. If a credit event occurs for the reference entity, the note’s payoff is reduced, potentially to the recovery value of the reference entity, and the investor may receive less than the original principal. Issuers typically hedge the embedded credit risk through protection transactions, while the exact payoff depends on the contract’s terms, such as the reference entity, event definitions, and settlement mechanics.

CLNs can be funded or unfunded, and may be collateralized or uncollateralized. They can involve a single reference entity or a basket of entities and may include features like step-up coupons or early termination options. They are commonly traded over-the-counter and may be issued in SPV structures to isolate credit risk.

Uses and markets: CLNs are used to obtain yield enhancement or to express a view on credit risk without owning a separate CDS. They are generally targeted at sophisticated investors, and liquidity in the secondary market can be limited. Risks include issuer credit risk, reference entity risk, liquidity, complexity, and regulatory considerations.