Credit Linked Notes (CLNs)
Credit Linked Notes (CLNs) are structured financial products that are created by combining a bond or note with a credit derivative. The credit derivative acts as a form of insurance against the default risk of a particular borrower or group of borrowers.
To create a CLN, a bank or financial institution issues a bond or note that is backed by a specific pool of assets, such as loans or bonds. The issuer then enters into a credit derivative contract with a third party, such as a credit default swap (CDS), which provides protection against default by one or more of the underlying assets.
The CLN can be structured in a variety of ways. In some cases, the CLN will only provide protection against the default of a specific asset or borrower. In other cases, the CLN will provide protection against a group of assets or borrowers.
Investors in CLNs are attracted to them because they offer the opportunity to earn a higher return than traditional bonds or notes, while still providing some protection against default risk. Additionally, CLNs can be customized to meet the specific needs of investors, such as a desire for a higher yield or a lower risk profile.
However, CLNs can also be complex and difficult to understand, and they may involve significant counterparty risk. Counterparty risk arises when the third-party issuer of the credit derivative is unable to meet its obligations under the contract in the event of a default. This risk can be mitigated by ensuring that the issuer of the credit derivative has a strong credit rating and sufficient collateral to cover its obligations.
CLNs have been used in a variety of applications, such as to provide funding for infrastructure projects or to finance real estate developments. However, like other structured financial products, CLNs played a role in the 2008 financial crisis, and their complexity and lack of transparency have been criticized.
In conclusion, Credit Linked Notes (CLNs) are financial products that combine a bond or note with a credit derivative to provide investors with an opportunity to earn a higher return than traditional bonds or notes while still providing some protection against default risk. While CLNs can be complex and involve significant counterparty risk, they continue to be used in a variety of applications in the financial markets.