What is a credit-linked note and what risks does the investor face?
I'm reviewing structured credit products for FRM Part I and ran into credit-linked notes (CLNs). I understand they combine a bond with a credit default swap somehow, but I'm confused about who bears what risk. Could someone explain the structure and the main risks to the note buyer?
A credit-linked note (CLN) is a funded credit derivative that packages a credit default swap (CDS) inside a bond structure. The investor buys the note (puts up cash), and in return receives coupon payments that include a spread for bearing the credit risk of a reference entity.
How It Works
Suppose Harborview Capital issues a CLN referencing the credit of Ashford Industries:
- The investor pays $10 million to buy the CLN from Harborview.
- Harborview places the $10 million in a collateral account (typically invested in high-quality securities like Treasuries).
- The investor receives SOFR + 250 bps quarterly — the extra 250 bps is compensation for bearing Ashford's default risk.
- If Ashford does not default before maturity, the investor gets back the full $10 million principal.
- If Ashford defaults, the investor suffers a loss equal to (1 − Recovery Rate) x $10 million. With a 40% recovery, the investor loses $6 million.
Risks to the Note Buyer:
| Risk | Description |
|---|---|
| Credit risk | The primary risk — if Ashford defaults, principal is impaired |
| Issuer risk | If Harborview itself fails, the collateral may not be returned |
| Liquidity risk | CLNs trade over-the-counter with thin secondary markets |
| Correlation risk | If the reference entity and the issuer are correlated, both can fail together |
| Mark-to-market risk | Spread widening on Ashford causes the CLN price to drop even without default |
Why Use a CLN Instead of a Plain CDS?
CLNs are funded — the investor posts cash upfront, which eliminates counterparty risk for the protection buyer (Harborview). This makes them attractive for investors who cannot trade unfunded CDS directly, such as certain insurance companies or pension funds.
For more on structured credit, explore our FRM Part I practice questions.
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