Credit Enhancement

Updated on January 5, 2024
Article byAbhilash Ramachandran
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Credit Enhancement?

Credit Enhancement is a strategy adopted by companies wherein they take various internal and external measures to improve their creditworthiness, with the primary aim to procure better terms for repaying their debt and reduce the risk of the investors of specific structured products in the financial market.

Organizations or Issuers predominantly engage in credit enhancement strategies to lower the interest that needs to be paid for specific security since high creditworthiness means a good credit rating, which eventually means that an investor’s investment will reap benefits as promised when the security is issued in the market. Inversely, when the creditworthiness is low, the credit rating will be poor, making it unfavorable for investors to invest since they might end up losing their investment.

Key Takeaways

  • Credit enhancement is a strategy businesses use to increase their creditworthiness through various internal and external actions. This strategy primarily serves to obtain better terms for debt repayment and lower investor risk for certain structured products on the financial market.
  • Credit improvement might be internal or external, depending on the technique employed. Internal improvement refers to the company’s processes to improve the credit situation. An external enhancement is any action taken from the outside to increase creditworthiness.
  • It is intended to provide a win-win scenario for the lender (investor) and the borrower (business). It guarantees an investor’s money security.

Types of Credit Enhancement

Credit enhancement can be either internal or external, depending on the strategy involved. The activities are done internally in an organization that enhances the credit scene are referred to as internal enhancement. Any external support taken to improve creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new more can be termed an external enhancement.

Credit Enhancement

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#1 – Internal Enhancement


The most commonly used credit enhancement technique is over-collateralization. As the name suggests, the value of the collateral is higher than the security itself. Since the underlying collateral is of a much higher value, an investor can rest assured in case of an event of default.

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Excess Spread

The excess spread refers to the interest that is in excess after all expenses of asset-backed securityAsset-backed SecurityAsset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card more are covered. It is related to over-collateralization. It is the difference in the interest rate gained from the underlying collateral and the interest paid on the security issued. The excess spread allows breathing space for organizations at times when it is in a loss-making phase.

Senior and Subordination Tranches

A senior or subordinated structure improves the internal creditworthiness of an organization. Cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more are segregated and prioritized as senior or subordination based on their seniority. A senior tranche would mean it has the highest seniority in the cash flow, and subordinates would be lower. The tranche structure of senior and subordination serves as a protective layer for senior tranches. Senior tranches have a better rating than that insubordination.

#2 – External Enhancement

Cash Collateral Account

A cash collateral account is an account that an issuer uses in case of any income deficit. The organization can borrow a certain amount of money from a commercial bank to buy commercial paper (CP)Commercial Paper (CP)Commercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory more instruments of the highest credit quality. The Cash Collateral account ensures credit enhancement because, when there are problems with asset-backed security, the organization can sell the commercial paper and repay the amount borrowed from the investors.

Letter of Credit

In case of a shortfall, a bank or any other financial institution is paid a fee to compensate the issuer when the payments default. Securities enhanced with a Letter of CreditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their more stand a chance to be downgraded. As a result, the issuer relies more on Cash Collateral Account when external support is required for credit enhancement.

Surety Bonds

Asset-backed securities that are backed by surety bondsSurety BondsSurety Bond is a contract made between 3 parties where the guarantor (surety) guarantees to fulfill the particular task or provide the required sum to the creditor (obligee) in case the debtor (principal) can't meet the obligation or debt. This protects the creditor from the loss of non-performance or non-payment. read more have the same rating as the issuer of the surety bonds. Credit enhancement works for asset-backed security with surety bonds as the backing since if the asset-backed security does not perform as expected, then the surety bonds can be used to reimburse the payments that have been defaulted.

Wrapped Securities

Insurance or guarantee by a third party concerning the payment of interest and principal is termed wrapped security. The third party may be the parent company of the issuer of the security or a bank or an insurance company. An AAA-rated company or a bank typically provides the guarantee.

Example of Credit Enhancement

ABC Inc. is raising capital by issuing a bond. It may engage in credit enhancement to reduce the rate of interest that it needs to pay for the bond to the investors. ABC Inc. would require a bank guaranteeBank GuaranteeThe term “Bank Guarantee,” as the name suggests, is the guarantee or assurance given by a financial institution to an external party if the borrower cannot repay the debt or meet its financial liability. In such an event, the bank will repay such an amount to the party that has been issued with the more on a portion of the principal amount. This makes the bond ‘Bank Guaranteed.’ In this case, the investor can rely on the bank’s guarantee to get his investment back if ABC Inc. defaults during the bond’s tenure. Suppose the rating of the bond at the time of issue was BBB; the bank guarantee would help the credit rating of the bond to increase to AA.

The improvement in the credit rating creates space for ABC Inc. to lower the interest rate and also ensures that the investors would get the interest payments and the principal amount on the guarantee of the bank.


  • It enables organizations to borrow at a lower rate of interest.
  • It improves the creditworthiness of the organization.
  • It encourages organizations to work on improving their creditworthiness.


  • An organization might end up trying different ways to enhance its creditworthiness instead of focusing on its core business.
  • Investors will favor securities with a higher credit rating, and securities with a low credit rating will not be invested.
  • It creates ambiguity among investors since credit enhancement might depict a false image of an issuer not performing well in its core business activities.


  • It is a strategy adopted by organizations to improve their creditworthiness.
  • There are two primary credit enhancement techniques – internal and external.
  • Credit Enhancement aims to create a win-win situation for the borrower (organization) as well as the lender (investor).
  • It ensures security for the investment made by an investor.

Frequently Asked Questions (FAQs)

What is credit enhancement in securitization?

Credit enhancements aim to lessen the credit risk for investors, consequently raising the investor certificates’ rating and decreasing the funding cost for the selling bank. The rating companies and underwriters choose the kind and quantity of credit upgrades.

What is a credit enhancement rating?

Credit enhancement is the term used to describe the artificial restructuring of credit instruments that raises their credit rating. If an organization issuing bonds has a bond with a credit rating of BB+, it may employ credit enhancement procedures to increase the bond’s credit rating to AA+ or higher.

What is a credit enhancement guarantee scheme?

By providing a credit enhancement guarantee to member lending institutions (MLIs), who would then give these businesses financial support, the program seeks to encourage entrepreneurship among the Scheduled Castes.

This has been a guide to What credit enhancement is and its Definition. Here we discuss the types of credit enhancement, including internal and external enhancement, and its advantages and disadvantages. You can learn more about Credit Analysis from the following articles –