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Credit Linked Notes (CLN)


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I can't get the whole concept of CLN.
As I understood, CLN are securities issued primarily by SPE/SPV that pool some sort of cash stream generating assets (mortgage, loans, bonds, ABS, etc) from some reference name and promise to stream those cash flows to the investors, who would subscribe to CLN securities. Investors buy CLN through market underwriters via subscription (like in case of normal IPO of debt/equity securities), paying upfront the PAR value to the CLN-issuer. Since PAR value is paid in upfront, CLN are called also as"funded" form of CDS.
CLN-issuer in this case is credit protection buyer, and investors are credit protection sellers.
What I do not understand is what happens next?
  1. What they will do with proceeds from CLN-issue (par value received from investors) ? Invested into risk-free securities (US treasuries/Govern bonds)? Or left aside to cover the losses at default?
  2. What will happen in case of default of reference name? What is payoff and how it is distributed,
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Hi @hamu4ok, re your second question: what do you mean by "how it is distributed"? I have understood so far that the CLN buyer receives only the recovery rate (i.e. the percentage of this recovery rate multiplied by the CLN notional for that respective buyer), so technically a buyer of a higher notional amount of the same CLN will receive in case of default a higher amount than the buyer of a smaller CLN notional. I don't remember the existence of seniority with regards to CLN so the amount of notional should be the only criterium for the distribution in case of default. I don't know if this helps?

Re your first question: I am not sure, but I believe the par value received from investors will be kept as a "backup" in order to cover the losses at default, but this could also depend on the risk profile of the CLN issuer (i.e. they also might reinvest the par received in other instruments/strategies in order to maximize their returns.


my take on #2 is: CLN-issuer is the protection buyer in the sense that protection seller assumes counterparty risk. This obvious point is critical in understanding what happens in a default situation. The seller get above normal interest rates for assuming this CP risk and also, because in case of default, the protection buyer holds the right to withhold making interest or principal payment of the securities he had issued (the reference). In short, t=0 he issues securities and sells them ("funded", he gets proceeds). t=1, t=2 etc he makes above-market rate interest payments t=3 default, he stops payments and because of default he pockets the difference (proceeds - whatever payments he had made up to default at t=3 + of course the recovery rate times notional)

2 observations I intuitively make. 1- A firm with dubious credit rating that wants to obtain funds in the market can issue CLN, and an investor searching for yield can accept it. 2- The other thing is, strangely enough, the issuer has some interest in defaulting to make "profit" out of this scheme. so not sure the legal mechanics behind this...