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A Credit Linked Note (CLN) is a structured product that transforms credit risk into a coupon. The investor buys a note and simultaneously takes on the credit risk of a reference entity. If no credit event occurs, the investor earns the bond yield plus the credit default swap (CDS) spread as an enhanced coupon. If a credit event occurs, the investor loses principal proportional to the loss given default.
A single-name CLN decomposes into: Bond + Short CDS. The investor is effectively selling credit protection to the issuer. The CDS spread premium funds the enhanced coupon. If the reference entity defaults, the investor absorbs the loss: principal × (1 − Recovery Rate). With a typical recovery of 40%, the loss is 60% of notional.
Three quantities are linked: Spread = PD × LGD, where PD is the annual probability of default and LGD is loss given default (1 − Recovery Rate). A BBB-rated company with a 200 basis point CDS spread and 40% expected recovery implies an annual default probability of 200bp / 60% = 3.33%. This relationship is the fastest way to convert between spreads and default expectations.
A First-to-Default (FTD) CLN references multiple entities — say 5 investment-grade names. If any one defaults, the investor bears the loss. The spread is dramatically higher than a single name: FTD Spread ≈ Single Spread × (N − ρ × (N − 1)). With 5 names at 20% correlation and 100bp single-name spreads, the FTD spread is roughly 100 × (5 − 0.20 × 4) = 420bp. The investor earns 4.2% enhanced coupon for bearing the first-to-default risk.
At zero correlation, the FTD spread approaches N times the single-name spread — maximum. At perfect correlation, all names default together or survive together — the FTD behaves like a single name and the spread collapses to 1x. Lower correlation means higher FTD spread but also higher risk, since defaults are more likely to be independent and trigger the note.
A CLN is a structured product where the investor buys a bond and takes on the credit risk of a reference entity. If no default occurs, the investor earns an enhanced coupon funded by the CDS spread. If the reference entity defaults, the investor loses part of their principal based on the loss given default (typically 40 to 60% of notional).
A First-to-Default CLN references a basket of multiple credit names (typically 3 to 7). The investor earns a higher spread but bears the risk of the first default in the basket. If any single name defaults, the investor absorbs the loss. The FTD spread is a multiple of the single-name spread, depending on the number of names and their correlation.
Lower correlation means defaults are more independent, making it more likely that at least one name defaults in a basket. This increases the FTD spread (and risk). Higher correlation means names tend to default or survive together, reducing the additional risk from having multiple names. At perfect correlation, the FTD basket behaves like a single-name CLN.
FinLingo covers credit derivatives in Level 6 (10 units) and credit structured products in Level 5. Build single-name and basket CLNs in The Lab. Level 1 is free.
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