A note is much like a bond in that it has regular payments that are usually paid on a semi-annual basis, however, a note can be customized. A credit-linked note, also known as a CLN, is a note with a credit default swap attached. The issuing company sells the credit default swap to the bank and receives an annual fee, which is then passed on to the investors of the note in the form of higher return. The credit default swap also allows the creditor or bank to transfer the risk of default on the note back to the company if the company cannot pay its investors. So the credit-linked note structure provides banks with insurance against default risk, and companies, or issuers, with the ability to pay investors a higher rate of return.
In order to truly understand what a credit-linked note is, it is important to understand what a credit default swap is. A credit default swap, also referred to as a CDS, is a contract which allows the buyer to sell the risk associated with default in exchange for a fee which is paid annually to the seller; this is much like the premium paid on car insurance. If something happens to the car, the insurance company pays for the expenses related to the accident.
In order to create a credit-linked note, the issuer sells a CDS to the bank that is underwriting or backing the note. Top investment banks command higher amounts of funding for note and bond offerings. These top investment banks, however, don't like risk, so they buy a CDS as a form of insurance against default on the note.
The structure of the credit-linked note is tricky. A special purpose entity or trust is created which is affiliated with the issuing company. The special purpose entity purchases AAA-rated investment securities — these securities are considered to be risk-free securities. At the same time, the special purpose entity sells a CDS to the bank which is underwriting the note. The credit-linked note is linked to both the AAA-rated investment securities and the credit of the company which created the special purpose entity. If both the AAA-rated paper and the company perform well, the investor receives the stated value of the note or par value at maturity. If either defaults, however, the investor gets pennies on the dollar, which is also known as the recovery value.
In case of company default, the company must pay the investment bank the difference between par value and the recovery value, which is tricky if the company can't even pay its investors. To accomplish the required payout, the company sells AAA-rated investment securities which are not linked to the defaulted company. These are the securities which are embedded in the credit-linked note through the CDS. In this way, the bank is insured against major losses regardless of the outcome.
It is important to note that the term “credit” in structured finance refers to the possibility or likelihood of loss due to a negative event. A loss is anything less than timely interest payments or full repayment of the principal over the life of the note. It is also important to note that in the world of credit products, usually the seller incurs the risk and the buyer pays a fee to the seller. The buyer is paying for protection and the seller is providing protection in exchange for an annual premium or payment.