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CLN (credit-linked notes)


A CLN combines a credit default swap (CDS) and a medium term note to deliver a security having both bond and derivative characteristics. A CLN may have a fixed or floating rate where the interest and principal payments are referenced to one or more reference credits. CLNs can be linked to a specific corporate loan or security through to a portfolio of securities, sovereign debt instruments or indices. Holders of CLNs have an exposure to, but do not own, the reference credits. In effect, CLN holders buy credit risk (or sell credit protection) on the reference credits from a counterparty selling credit risk (or buying credit protection), often through a special purpose vehicle (SPV).

In its simplest, single-name CLN offers exposure to a single reference credit. Holders of CLNs will usually be entitled to enhanced interest (called a spread pick-up, to reflect exposure to the credit risk) and redemption of principal at par if there has been no credit event affecting the reference credit. If a credit event occurs to the reference credit, the redemption amount of the CLNs will be reduced, and CLN investors will experience a loss. The terms of the CLNs may also provide that if a credit event occurs, the CLNs will be redeemed by delivery of the reference credit to the noteholders.

A CLN may or may not be collaterised. If it is, the proceeds of the CLN will be used to purchase a risk-free collateral e.g. government bonds, and the noteholdersE˝f claim under the CLNs will in those circumstance be limited to the liquidation proceeds of the collateral.

As with the CDS, there are a number of credit events that can be included in the terms of the CLN: Bankruptcy, Restructuring, or Failure to Pay.

CLNs are normally issued by a SPV or trust which will, in connection with the issuance of the CLNs, enter into a credit default swap with a rated counterparty. The dominant credit risk that the holders of the CLNs assume is that of the reference credit and that of the swap counterparty.

CLNs provide investors with the opportunity to synthetically create credit exposures and gain access to names and risk profiles that they may not have direct access to in the debt capital markets, enhancing portfolio diversity and yield. It also provides investors with an alternative to the equity markets where they can gain broad exposure to companies, sectors and countries, often without exposure to exchange rate risk.

derivativeslawyer.com

Last updated 14 February 2006

The above notes are intended to provide only general outlines and should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They should never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof.

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