What Is Credit Enhancement?
Credit enhancement is a strategy for improving the credit risk profile of a business, usually to obtain better terms for repaying debt.
In the financial industry, credit enhancement may be used to reduce the risks to investors of certain structured financial products.
[Important: Credit enhancement reduces the default risk of the company's debt and thus can make it eligible for a lower interest rate.]
Understanding Credit Enhancement
A business that engages in credit enhancement is providing reassurance to a lender that it will honor its obligation. This can be achieved in various ways:
- By providing additional collateral
- By obtaining insurance guaranteeing payment
- By arranging for a third-party guarantee
The company might also increase its cash reserves or take other internal measures to demonstrate its ability to pay its debts. Credit enhancement reduces the credit risk/default risk of the company's debt and thus can make it eligible for a lower interest rate.
Credit Enhancement of a Bond Issue
A company that is raising cash by issuing a bond may use credit enhancement to lower the interest rate it must pay to investors. If the company can get a guarantee from a bank to assure a portion of the repayment, the rating on the bond issue might improve from BBB to AA. The bank guarantee has enhanced the safety of the bond issue's principal and interest. The issuer now can save money by offering a slightly smaller interest rate on its bonds.
Credit Enhancement on Structured Products
Structured products derive their value from underlying assets such as mortgages or credit card receivables. Some of those assets are riskier than others. For such investment products, credit enhancement serves as a cushion that absorbs potential losses from defaults on the underlying loans.
- In business, credit enhancement is used to make a business more creditworthy and reduce the cost of borrowing.
- In financial services, credit enhancement is used to protect the investor against some of the potential risks of the investment.
- In either case, insurance against risk can be a form of credit enhancement.
Credit enhancement is a key part of the transaction in structured finance. Below are several of the different types of credit enhancements that are used.
Subordination or Tranching
Securitized financial products such as asset-backed securities (ABS) are issued in classes, or tranches, of securities, each with its own credit rating. The tranches are categorized from the most senior to the most subordinated, or junior.
Credit enhancements are attached to the highest-rated tranches, giving their buyers priority in any claims for repayment against the underlying assets. The junior tranches carry the greatest risks and pay the highest yields. If a loan in the pool defaults, any loss is absorbed by the junior tranches.
These bonds or insurance policies are provided by an insurance company to reimburse the asset-backed security for any losses. An ABS paired with surety bonds has a rating almost equal to that of the surety bond’s issuer.
Letter of Credit
A bank issues a letter of credit as a promise to reimburse the issuer for any cash shortfalls from the collateral, up to an established amount.
A third party, such as an insurance company, ensures the security against any losses by agreeing to pay back a certain amount of interest or principal on a loan or buy back some defaulted loans in the portfolio.
The face value of the underlying loan portfolio is larger than the security it backs, so the issued security is overcollateralized. Even if some of the payments for the underlying loans are late or in default, principal and interest payments on the asset-backed security can still be made.