What characteristic defines credit linked notes (CLNs)?

Credit linked notes (CLNs) are defined by their structure, which incorporates an embedded credit default swap (CDS). This means that the payment of interest or the return of principal on these securities is contingent upon the credit performance of a specified reference entity. If a credit event occurs, such as a default by the entity, it can lead to a reduction in the payment obligations related to the CLNs, reflecting the risk of the underlying credit exposure.

The embedded CDS feature is fundamental to how CLNs operate, as it effectively transfers the credit risk associated with the reference entity to the note holders. This characteristic allows investors to take on tailored credit risk, providing a unique investment opportunity that can offer higher yields in exchange for accepting potential credit-related losses.

This focus on the credit risk component differentiates CLNs from other financial instruments that may not carry such explicit credit risk ties or mechanisms to hedge against them.