Credit-Linked Note

The Credit-Linked Note (CLN) is a financial instrument or product that allows issuers to hedge or shift the risk associated with a security to a third party willing to take responsibility for the default risk. All other common market risks stay intact with the original buyer, along with the investments purchased by them.

Many derivative products in the financial market are designed to allow firms to shift or transfer the risk exposure to other entities or investors willing to take on the risk. A credit-linked note is considered one of the safest derivatives as it operates like bonds and pays regular interest to investors. CLNs are a combination of a bond and a credit default swap, which allows issuers to shift the risk to buyers. Buyers can be individuals or institutional investors, while financial institutions, banks, and investment banks usually act as issuers.

• Credit-linked notes are funded credit derivatives that reduce or contain an issuer’s default risk exposure by transferring it to other entities (buyers/investors) interested in accepting the risk in exchange for high returns.
• CLNs are bonds combined with credit default swaps; they allow issuers to swap or shift their risk to other investors.
• Issuers use CLN as a hedging instrument to protect their funds in case of a specific credit event that may cause losses.
• Investors (individuals and institutional) invest in CLNs since they offer higher yields than regular bonds as a reward for accepting the risk exposure associated with these complex financial instruments.

A credit-linked note is a bond that can swap or transfer the risk exposure to other investors since a credit default swap is attached to this financial instrument. These are typically issued via a medium-term note (MTN) program, which specifies how an issuer can issue debt securities. Buyers willingly bear the risk of such instruments for handsome returns. It is important to note that buyers and investors can be the same or different in such arrangements.

A buyer is an entity that purchases or acquires a CLN. Hence, in most cases, buyers are investors. However, if the entity providing the funds to purchase the CLN is different from the CLN acquirer, the buyer and investor become two independent entities.

Companies offer credit-linked note structured products to investors. Investors willing to undertake the risk invest in such instruments. Another entity, called the Reference Entity, is involved in this process. The reference entity is a financial institution, a government agency, or a large corporation.

The principal repayment is governed by an issuer’s creditworthiness and by the creditworthiness of the third party acting as a reference entity. Investors who take the risk exposure receive regular interest payments, also known as coupons. While this interest is similar to the interest paid on regular bonds, the coupon rate is higher than other bonds or debt instruments. This is because of the credit risk these investors willingly accept. 

The credit-linked note definition states that customers are issued loans for CLN creation. The bank or financial institution extending the loan can choose to earn interest on this loan as the borrower repays it, or it can sell the loan to another entity. When a bank sells such loans, they are categorized and grouped based on similarities in terms of risk or rating. Financial instruments classified in this manner are then sold to investors as debt securities with a maturity period and a coupon rate. If the reference entity defaults, an amount equal to the recovery rate is offered to investors.

Below are two examples to help readers understand the concept further.

Example #1

Assume Laura wants to buy bonds issued by Peter. However, she is skeptical that Peter may default, so Laura creates an underlying portfolio called a reference asset base. The credit-linked note pricing depends on the performance of the reference asset. Laura issues another set of securities backed by Peter’s bonds and sells it to investors who pay her upfront. In exchange, Laura promises periodic payments to this group of investors.

In this case, Laura contacted a group of investors willing to take responsibility for the default risk involved in this arrangement. With this, she separates herself from the possibility of credit risk. Laura will now receive money from Peter with a percentage added as compensation for taking the risk.

In the real world, investors receive a high return for accepting the risk; all other market risks remaining the same.

Example #2

According to a Sep 2022 report, Pacific Western Bank (HQ: Los Angeles, California) issued its first credit-linked note. The deal totaled $2.68 billion. With this arrangement, the risk associated with approximately 3,819 qualified and nonqualified mortgage loans was transferred to investors through a financial guarantee transaction.

The bank only deals with interest payments for Class M and B noteholders, and all the funds are kept in a collateral account. According to Fitch Ratings, the credit quality is solid as borrower creditworthiness is high, with a FICO score of 764. The debt-to-income ratio is 39.5%, and the original combined loan-to-value ratio was 69.7%.

The benefits of credit-linked notes are:

• They allow firms to shift the credit exposure to those willing to take the risk.
• These instruments offer a higher yield to investors than individual investments in underlying assets of the same variety.
• Credit-linked notes offer semi-annual payments as bonds do, but they have a default swap.
• Issuers (banks, investment banks, and financial institutions) sell CLNs because they bring the cost of funding up to or below the target cost.
• CLNs are created by trust funds and are collateralized by AAA securities and other asset pools.
• Issuers can meet their risk diversification objectives while investors get access to many instruments without obtaining or accepting ownership of the underlying assets.

The risks of credit-linked notes have been discussed below.

• Investors accepting the credit risk of an issuer can lose money if the entity defaults.
• CLNs are complex financial instruments. Therefore, unsound investment decisions are a possibility.
• If the reference entity or entities default or a credit event revolving around a reference entity occurs, investors might be forced to bear losses.
• As CLNs are not as liquid as bonds (of other types or forms), selling them is challenging if investors need funds before maturity.
• Any changes in the interest rate structure in a given region can affect the interest rate on CLNs.

The differences between credit-linked notes, credit default swaps, and bonds are listed below.

This article has been a guide to what is a Credit-Linked Note (CLN). Here, we explain it with its examples, risks, and comparison with credit default swap, and bond. You may also find some useful articles here -

• Structured Notes
• Credit Derivatives
• Quanto Swap