Meaning
Methods used by a borrower improve the credit profile of a structured financial product or debt obligation to obtain better financing terms. Lenders view credit enhancement as a way to lower the probability of loss on a specific loan or bond. This can be achieved through internal structural features or external third party guarantees.
Structural Support
Over collateralization provides a buffer by ensuring the value of the assets exceeds the value of the debt issued. In many asset backed securities, credit enhancement involves creating different tiers of debt where junior tranches absorb losses before senior ones. This prioritization protects the most senior investors.
Reserve accounts are often funded at the start of a deal to cover any temporary shortfalls in cash flow from the underlying assets. Excess spread, which is the difference between interest collected and interest paid, also acts as a primary internal protection mechanism.
Rating Benefit
Improvement in credit scores allows issuers to access capital markets at lower interest rates. Because credit enhancement reduces the perceived risk for investors, it can move a bond from a speculative grade to an investment grade. Higher ratings attract a broader pool of institutional investors who have strict risk mandates.
Capital Cost
Fees paid for insurance or bank guarantees represent the primary expense of this strategy. While credit enhancement reduces the interest rate on the debt, the cost of the enhancement itself must be subtracted from the savings to determine the net benefit. Complex legal agreements are necessary to define the triggers for when the enhancement must be paid out to investors.
