Credit-linked Notes

A credit-linked note (CLN) is a cash market-structured note with a credit derivative,
typically a CDS, embedded in the structure. The investor in the CLN sells credit
protection. Should the reference asset underlying the CLN default, the investor (i.e.
protection seller) will suffer a credit loss. The CLN issuer is a protection buyer. Its
obligation to repay the par value of the security at maturity is contingent upon the
absence of a credit event on the underlying reference asset. Figure 11.4 shows the
cash flows of a CLN with an embedded CDS.
A bank can use the CLN as a funded solution to hedging a company’s credit risk
because issuing the note provides cash to the issuing bank. It resembles a loan
participation but, as with other credit derivatives, the loan remains on the bank’s
books.
The investor in the CLN has sold credit protection and will suffer a loss if XYZ
defaults, as the issuer bank would redeem the CLN at less than par to compensate
it for its credit loss. For example, a bank may issue a CLN embedded with a fixed
payout (binary) default swap that provides for a payment to investors of 75 cents on
the dollar in the event a designated reference asset (XYZ) defaults on a specified
obligation. The bank might issue such a CLN if it wished to hedge a credit exposure
to XYZ. As with other credit derivatives, however, a bank can take a short position if
it has no exposure to XYZ, but issues a CLN using XYZ as the reference asset. Like
the structured notes of the early 1990s, CLNs provide a cash market alternative to
investors unable to purchase off-balance sheet derivatives, most often due to legal
restrictions.
CLNs are frequently issued through special-purpose vehicles (SPV), which use the
sale proceeds from the notes to buy collateral assets, e.g. Treasury securities or
money market assets. In these transactions, the hedging institution purchases
default protection from the SPV. The SPV pledges the assets as collateral to secure
any payments due to the credit hedger on the credit default swap, through which
the sponsor of the SPV hedges its credit risk on a particular obligor. Interest on the
collateral assets, plus fees on the default swap paid to the SPV by the hedger,
generate cash flow for investors. When issued through an SPV, the investor assumes
credit risk of both the reference entity and the collateral. When issued directly, the
investor assumes two-name credit risk; it is exposed to both the reference entity and
the issuer.
Credit hedgers may choose to issue a CLN, as opposed to executing a default swap,
in order to reduce counterparty credit risk. As the CLN investor pays cash to the
issuer, the protection buying issuer eliminates credit exposure to the protection
seller that would occur in a CDS.
Dealers may use CLNs to hedge exposures they acquire by writing protection on
default swaps. For example, a dealer may write protection on a default swap, with
XYZ as the reference entity, and collect 25 basis points. The dealer may be able to
hedge that exposure by issuing a CLN, perhaps paying LIBORò10 basis points, that
references XYZ. The dealer therefore originates the exposure in one market and
hedges it in another, arbitraging the difference between the spreads in the two
markets.