ABC Investments would like to take on the risk associated with the debt of XYZ Corp., but all of XYZ's debt is composed of bank loans and ABC Investments cannot simply sell protection in a Credit Default Swap (CDS) because its investment policy prevents it from entering into a derivatives contract. What structured financial instrument can ABC Investments use to the desired exposure?

A. Guaranteed certificate
B. Credit-linked note
C. Inverse floater

Correct Answer: B

One way of gaining the desired exposure to XYZ's debt is for ABC Investments to purchase $100 million in Credit Linked Notes that reference XYZ Corp. The issuer of the notes may take ABC Investments' $100 million and buy highly-rated debt obligations to serve as collateral for its CLN liability towards ABC Investments. At the same time, the CLN issuer enters into a credit default swap with a third party, selling protection against a default by XYZ Corp. From that point on, the CLN issuer will simply pass through the cash flows associated with the credit default swap to ABC investments. In the event of default by XYZ Corp., the CLN issuer will pay its default swap counterparty and the Credit Linked Note terminates with ABC Investments receiving only the recovery value of XYZ's defaulted debt. If no default occurs, ABC Investments will continue to receive the coupon payments associated with the Credit Linked Note until its maturity date, at which point it will also receive its principal back. It should then be clear that a credit linked note is simply a funded way of entering into a credit derivatives contract.