How Credit Enhancement Works?

Credit enhancement refers to the artificial restructuring of credit products which results in the improvement of its credit rating. In simple words, if a bond being issued by an entity has credit rating BB+, it can use credit enhancement techniques to increase its credit rating to AA+ or so.

There are obvious benefits of using credit enhancement techniques. Some of them have been listed below.

Firstly, from the issuer’s point of view, the benefit is twofold. Firstly, when the credit rating increases, the security becomes palatable to a lot more investors. It is a known fact that many pension funds and mutual funds only invest in AA assets. Hence, when the rating of the assets is increased, it becomes easier to sell the security. This ends up increasing the liquidity of the underlying security.

Secondly, credit enhancement significantly decreases the cost of borrowing. If the size of the issue is large, this could mean substantial dollar savings for the entity involved.

Investors, also benefit from such arrangements. This is because their money is now secured by more than one parties and hence the likelihood of default decreases exponentially.

Since all the parties gain from credit enhancements, they have been widely used in the past few years. Some of the commonly used forms of credit enhancement are as follows:

  • Over-Collateralization: It is a known fact that secured loans are cheaper than unsecured loans. This is because, in the event of a default, lenders can recover their money by selling the assets which were used as collateral. However, a lot of times, the value of these assets fluctuates as well. Hence, having collateral does not ensure that 100% of the funds will be recovered.

    In such cases, overcollateralization can be used to reduce the cost of borrowing. In order to do so, the deal has to be structured in such a way that the amount of collateral provided exceeds the amount of the loan. For instance, if gold worth $100 is collateralized for a loan of $75, then the interest rate can be reduced. This is because even if the market for gold crashed 25% during the period, the investors could still recover 100% of their money by selling the underlying collateral. Overcollateralization is mostly used by individuals or small companies to lower their cost of borrowing.

  • Bank Guarantees: As far as corporations are concerned, bank guarantees are the most commonly used form of credit enhancement. This arrangement works because many times investors do not trust that the issuing company has the wherewithal to repay the loans it is undertaking. However, these same investors have a lot of faith in the financial situation of other entities such as banks.

    Under this arrangement, the issuing company pays a fee to the bank in order to guarantee the payments. Hence as far as the investors are concerned, it is like lending money to the bank which is much safer when compared to lending money to a company. As a result, investors are willing to accept a lower rate of interest. It needs to be understood that guarantees only work if they are issued by banks or other entities that people place trust in. The guarantee will have no meaning if it is issued by another firm whose financials are also questionable. Lastly, it also needs to be understood that the bank does not necessarily have to guarantee the entire loan. A partial guarantee may also be issued, and that will help in reducing the interest rates proportionately.

  • Credit Wrapping: Credit wrapping is another form of credit enhancement. It works in a similar manner when compared to bank guarantees. The difference is that credit wrapping is done by a monoline insurance company. These insurance companies work exclusively to improve the credit ratings of bonds. These insurers take a premium from issuing companies. Against this premium, they provide insurance to the investors. Hence, even if the borrower goes bust, the insurance company will pay the agreed upon principal as well as interest. As a result, investors do not have to consider the credit ratings of bond issuers. Rather, only the ratings of insurance companies remain relevant. Credit wrapping is commonly used by many municipalities when they issue bonds.

  • Tranching: Tranching is a credit enhancement method which was made infamous by the 2008 mortgage crisis. Under this method, the issuer divides securities into tranches. The first tranche is the riskiest and absorbs all losses before they are passed on to anyone else. This method of loss distribution is different. Normally, losses are equally borne by all bondholders. However, tranching makes this distribution unequal. As a result, some bonds become riskier whereas others become less risky. This allows the issues to change the rating of some bonds to a higher level whereas the ratings of other bonds are reduced. The effect on the cost of borrowing may not be much. However, tranching makes it possible to sell risky assets to pension funds and mutual funds who are only authorized to buy high rated securities.

To sum it up, there are many credit enhancement techniques which are available to the issuer which can help reduce the overall cost of borrowing. This is the reason why there are special intermediaries who exist to facilitate credit enhancement.

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