Credit Enhancement
What Is Credit Enhancement?
Credit enhancement is a strategy for further developing the credit risk profile of a business, generally to get better terms for repaying debt.
In the financial industry, credit enhancement might be utilized to reduce the risks to investors of certain structured financial products.
[Important: Credit enhancement reduces the default risk of the company's debt and in this manner can make it eligible for a lower interest rate.]
Figuring out Credit Enhancement
A business that takes part in credit enhancement is giving consolation to a lender that it will respect its obligation. This can be accomplished in different ways:
- By giving extra collateral
- By getting insurance guaranteeing payment
- By sorting out for a third-party guarantee
The company could likewise increase its cash reserves or go to other internal lengths to demonstrate its ability to pay its debts. Credit enhancement reduces the credit risk/default risk of the company's debt and in this way can make it eligible for a lower interest rate.
Credit Enhancement of a Bond Issue
A company that is raising cash by giving a bond might utilize credit enhancement to bring down the interest rate it must pay to investors. In the event that the company can get a guarantee from a bank to guarantee a portion of the repayment, the rating on the bond issue could improve from BBB to AA. The bank guarantee has enhanced the safety of the bond issue's principal and interest. The issuer currently can set aside cash by offering a somewhat more modest interest rate on its bonds.
Credit Enhancement on Structured Products
Structured products get their value from underlying assets, for example, mortgages or credit card receivables. A portion of those assets are riskier than others. For such investment products, credit enhancement fills in as a cushion that absorbs expected losses from defaults on the underlying loans.
Key Takeaways
- In business, credit enhancement is utilized to make a business more creditworthy and reduce the cost of borrowing.
- In financial services, credit enhancement is utilized to safeguard the investor against a portion of the possible risks of the investment.
- Regardless, insurance against risk can be a form of credit enhancement.
Special Considerations
Credit enhancement is a key part of the transaction in structured finance. Below are several of the various types of credit enhancements that are utilized.
Subordination or Tranching
Securitized financial products, for example, asset-backed securities (ABS) are issued in classes, or tranches, of securities, each with its own credit rating. The tranches are classified from the most senior to the most subordinated, or junior.
Credit enhancements are connected to the highest-rated tranches, giving their buyers priority in any claims for repayment against the underlying assets. The junior tranches carry the most serious risks and pay the highest yields. In the event that a loan in the pool defaults, any loss is absorbed by the junior tranches.
Surety Bonds
These bonds or insurance policies are given by an insurance company to repay the asset-backed security for any losses. An ABS paired with surety bonds has a rating practically equivalent to that of the surety bond's issuer.
Letter of Credit
A bank issues a letter of credit as a guarantee to repay the issuer for any cash shortages from the collateral, up to a laid out amount.
Wrapped Securities
A third party, for example, an insurance company, guarantees the security against any losses by consenting to pay back a certain amount of interest or principal on a loan or buy back a few defaulted loans in the portfolio.
Overcollateralization
The face value of the underlying loan portfolio is bigger than the security it backs, so the issued security is overcollateralized. Even assuming that a portion of the payments for the underlying loans are late or in default, principal and interest payments on the asset-backed security can in any case be made.
