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Credit Linked Note (CLN)



Definition

A Credit Linked Note (CLN) is a type of funded credit derivative, a financial instrument designed to separate and then transfer the credit risk of a specific underlying loan. This allows investors to achieve exposure to the underlying loan without funding it directly. Essentially, the issuer creates a CLN by purchasing a risky bond and then selling it as a packaged product to investors, also providing protection against credit events.

Phonetic

The phonetics for the keyword “Credit Linked Note (CLN)” would be:Credit – /’krɛdɪt/Linked – /’lɪŋkt/Note – /noʊt/CLN – /siː ɛl ɛn/

Key Takeaways

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  1. Form of Funded Credit Derivative: Credit Linked Note (CLN) is a form of funded credit derivative that is structured as a security with an embedded credit default swap that allows the issuer to transfer a specific credit risk to credit investors. It provides investors with exposure to an underlying credit or a basket of credits in a commoditized and easily transferable format.
  2. Risk Transfer Mechanism: CLNs act as a risk transfer mechanism between the issuer and investors. In other words, by investing in a CLN, an investor is taking on the credit risk of the underlying asset. If that underlying asset defaults, the investor will lose a proportion or the entire amount of their investment.
  3. Return and Interest: The investors in a Credit Linked Note typically receive a higher return than other debt securities because they are assuming an additional risk of default. The return is usually in the form of interest payments over the life of the note and finally, the redemption amount when the note matures unless there is a default event before maturity.

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Importance

The Credit Linked Note (CLN) is a significant financial term and instrument due to its unique structure that offers a way to invest indirectly in a specified asset or entity. CLNs enable significant risk transfer for investors who own risky assets while offering the note’s issuers a way to attain funding. The return on a CLN is determined by the credit performance of a reference entity, therefore, it plays a key role in the assessment and allocation of credit risks, allowing investors to broaden their investment portfolio with assets they may not typically have direct access to. The embedded credit default swap within the CLN provides the advantage of default protection. Hence, understanding this term is crucial for anyone involved in investing, finance, or the credit market.

Explanation

Credit Linked Notes (CLNs) serve an important purpose in the field of investment and risk management, particularly in relation to credit risk. Essentially, a CLN is a security with an embedded credit default swap, allowing the issuer to transfer a specific credit risk to the note holders. For investors, it represents an option to gain exposure to specific fixed income assets, while allowing issuers to offload certain credit risks associated with these assets. It’s a flexible financial tool designed to separate and transfer credit exposure in intricate financing structures, which can help to improve overall portfolio diversification.In terms of its uses, CLNs have a wide breadth. For instance, financial institutions might use them for balance sheet management, particularly for transferring credit risk related to their loan portfolio. On the investor side, by investing in CLNs, one can attain an enhanced return compared to straightforward bonds due to the risk premium attached to the specific credit risk. Meanwhile, hedge funds and proprietors might use CLNs in their investment strategies as a convenient vehicle for taking on a position either in favor of or against a particular credit risk. In essence, CLNs allow for optimized risk-return scenarios and provide an additional level of investment flexibility.

Examples

1. Barclays Bank: In 2005, Barclays Bank issued a big credit linked note for BHP Billiton, the world’s largest mining company. This CLN was not only linked to the creditworthiness of BHP Billiton, but also to the creditworthiness of various commodities it dealt with, including copper and oil. It provided investors with a high yield as long as none of the reference entities defaulted during the life of the note.2. AXA Investment Managers: In 2016, the asset management company AXA IM launched a new credit linked notes fund for professional clients. It was designed to provide investors with exposure to a diversified portfolio of CLNs and it was linked to the credit worthiness of corporate entities across a wide spectrum of sectors.3. Merrill Lynch: In 2002, Merrill Lynch issued a series of credit-linked notes tied to Enron – a major energy company that eventually went bankrupt due to fraudulent financial activities. Investors bought these notes expecting a high yield due to the perceived risk at the time. However, when Enron went bankrupt, the investors suffered significant loss as the credit risk materialized.

Frequently Asked Questions(FAQ)

What is a Credit Linked Note (CLN)?

A Credit Linked Note (CLN) is a financial instrument that combines a credit default swap with a regular note. It provides the note issuer with protection against credit events such as default, restructuring, or bankruptcy of an entity known as the reference entity.

How does a Credit Linked Note (CLN) work?

The issuer of a CLN, typically a special purpose vehicle (SPV), buys a bond from the reference entity and simultaneously enters into a default swap with the note buyer. If no default occurs, the investor gets a higher yield than the market rate. If a default does happen, the investor may lose some or all of their initial investment.

What is the benefit of investing in a Credit Linked Note (CLN)?

The main advantage of investing in a CLN is the high return rate. Since the risk is high in the event of a default, CLNs often offer higher returns compared to other securities.

Does the creditworthiness of the reference entity impact the CLN?

Yes, the creditworthiness of the reference entity directly influences the terms of the CLN. The higher the risk of credit default by reference entity, the higher the returns offered to the investor.

Who issues Credit Linked Notes?

Credit Linked Notes (CLNs) are typically issued by financial entities like banks, insurance companies or investment firms. These entities often use CLNs to transfer the credit risk of their loan portfolios to other parties.

How are Credit Linked Notes valued?

The value of a CLN depends on the credit quality of the reference entity or entities, the length of the note, the agreed-upon interest rates, and the global interest rate environment.

Can you redeem a Credit Linked Note (CLN) before maturity?

Whether a CLN can be redeemed before its maturity depends on the terms and conditions specified in the contract. In general, most Credit Linked Notes are not redeemable until maturity. However, under certain circumstances, early redemption may occur.

What happens if a Credit Event occurs?

If a Credit Event such as default, restructuring, or bankruptcy occurs, the investor is likely to lose part or all of their initial investment, or receive a decreased return, depending on the terms of the CLN.

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