abbreviated CLN, it is a tradeable security issued by an entity where the repayment of capital is conditional on some other third-party entity performing on an unrelated financial obligation.
For example, Big Bank Inc. may issue a €500m, five year 3.5 % CLN linked to Ruritania’s 10-year sovereign bond. During the life of the CLN, Big Bank Inc. will pay interest of 5% per year. At year five, it will only repay the principal of €500 if Ruritania has not defaulted on its 10-year bond.
If, however, Ruritania has defaulted, then Big Bang does not have to pay the principal. CLNs are one of the legal mechanisms used to structure synthetic securitisations. If the defaults that reduce the amount of principal payable are on a pool of assets and the CLN is one tranche of the overall credit risk of the pool the CLN becomes a securitisation.
Technical Note: Most CLNs are not all-or-nothing where a default by the third-party entity means that no capital is repayable. Usually, the CLN contains provisions to provide that if the issuer of the CLN receives some money from the third-party entity, as part of a restructuring or from the insolvency estate of the defaulted party, the issuer needs to pay the CLN investor an amount of principal equal to what it has so received.
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