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A credit linked note is a security created through a special purpose company or trust, designed to offer investors par value at maturity unless a referenced credit defaults. In the case of default, the investors receive a recovery rate.
The trust will also have entered into a default swap with a dealer. In case of default, the trust will pay the dealer par minus the recovery rate, in exchange for an annual fee which is passed on to the investors in the form of a higher yield on their note.
The purpose of the arrangement is to pass the risk of specific default onto investors willing to bear that risk in return for the higher yield it makes available. The CLNs themselves are typically backed by very highly-rated collateral, such as U.S. Treasury bonds.
The Italian dairy products giant, Parmalat, notoriously dressed up its books by creating a credit-linked note for itself, betting on its own credit worthiness.
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