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What is a credit linked note?

A credit linked note (CLN) is a funded credit derivative (see Practice Note: What are credit derivatives?). Unlike a credit default swap (which is in essence its unfunded equivalent), a CLN will be reflected on the balance sheet of the issuer of the CLN.

A CLN takes its underlying value from the credit risk of a third party, known as the 'reference entity'. At its most simple, a CLN is a note issued by an issuing entity (the protection buyer) whereby on the issue date the noteholder (or protection seller) pays the face amount of the note and thereafter receives an agreed rate of return until a credit event occurs on the underlying reference entity or the note matures. A CLN provides an investor with the returns of a potentially risky reference entity without needing to own that reference entity.

Who issues and buys credit linked notes?

Credit linked notes are generally issued by special purpose vehicles or financial institutions. They are typically purchased by financially sophisticated investors—pension funds, hedge funds,