Credit Linked Notes
In this blog post, we’ll be discussing credit linked notes (CLN), an increasingly popular investment vehicle the recent years. We’ll cover what a credit linked note is, its main characteristics, differences between a CLN and a straight bond, and the risks associated with investing in a CLN.
What is a Credit Linked Note?
A credit linked note (CLN) is a type of structured product that combines a bond with a credit derivative. The basic idea is that an investor purchases a bond issued by a financial institution (usually a bank), but the return on that bond is tied to the credit event of a third party company. In other words, the bond’s performance is linked to the credit risk of a specific issuing entity.
For example, let’s say that an investor purchases a CLN with a issuing entity of Company X. If Company X defaults on its debt, the investor may receive a reduced return or may even lose their entire investment. However, if Company X does not default, the investor will receive the full return on the bond.
Main Characteristics of Credit Linked Notes
Credit linked notes have several main characteristics that distinguish them from traditional cash bonds. First, they are often issued by a special purpose vehicle (SPV) rather than the issuing entity itself. Second, the coupon rate on a CLN is often higher than that of a comparable cash bond, reflecting the added credit risk. Finally, credit linked notes typically have a shorter maturity than cash bonds, often ranging from three to five years.
Difference Between a CLN and a Cash Bond
The primary difference between a credit linked note and a cash bond is that the return on a CLN is tied to the credit event of a third party. With a cash bond, the investor is lending money to the issuer and receives a fixed rate of return over the life of the bond. With a credit linked note, the investor is taking on the credit risk of the issuing entity in exchange for a higher potential return.
Risks of Investing in Credit Linked Notes
Investing in credit linked notes involves a number of risks:
- First and foremost, the investor is taking on the credit risk of the issuing entity. If the issuing entity defaults on its debt, the investor may lose some or all of their investment.
- Additionally, credit linked notes are often complex financial products that can be difficult to understand, which increases the risk of making an ill-informed investment decision.
- Another risk to consider is the liquidity of the investment.
- Credit linked notes may be less liquid than cash bonds, meaning that it can be more difficult to sell the investment if the investor needs to access their funds before the maturity date.
Credit linked notes can be a useful investment vehicle for investors looking for higher returns than traditional cash bonds. However, they also involve greater risk, including the credit risk of the issuing entity and the complexity of the product. As with any investment, it’s important to carefully consider these risks and do your due diligence before making a decision to invest in credit linked notes.
Credit Linked Notes are a very compelling investment that may offer attractive returns, but — as with any sophisticated product — clients should always make sure they fully understand the assumed risk.
If you have any questions or would like more information on this topic, please do not hesitate to contact us.