It is a structured note issued by a special purpose company or trust, designed to offer investors par value at maturity unless the referenced entity defaults.
In case of default, the dealer will pay the trust 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 Italian dairy products giant, Parmalat, notoriously dressed up its books by creating a credit-linked note for itself, betting on its own credit worthiness.
[1] A bank lends money to a company, XYZ, and at the time of loan issues credit-linked notes bought by investors.
The funds the bank raises by issuing notes to investors are invested in bonds with low probability of default.
The bank in turn gets compensated by the returns on less-risky bond investments funded by issuing credit linked notes.
However downstream, in the back office, difficulties can arise from failure to appropriately control the risks associated from the lack of data and compatibility of accounting platforms.