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 issuers 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:
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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