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 also reduces 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 the investment that is made by an investor 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, which makes it unfavorable for investors to invest since the investor might end up losing his/her investment.
Types of Credit Enhancement
Credit enhancement can be either internal or external, depending on the strategy involved. The activities done internally in an organization that enhances the credit scene is referred to as internal enhancement, whereas any external support taken to improve the creditworthiness can be termed as an external enhancement.
#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.
The excess spread refers to the interest that is in excess after all expenses of an asset-backed security is 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.
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Senior and Subordination Tranches
A senior or subordinated structure improves the internal creditworthiness of an organization. Cash flows are segregated and prioritized as senior or subordination on the basis of 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 deficit in income. The organization can borrow a certain amount of money from a commercial bank to buy commercial paper (CP) instruments of the highest credit quality. The Cash Collateral account ensures credit enhancement because, at the time of problems with asset-backed security, the organization can sell the commercial paper and repay the amount that is 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 Credit stand a chance to be downgraded, and as a result, the issuer relies more on Cash Collateral Account when external support is required for credit enhancement.
Asset-backed securities that are backed by surety bonds 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.
Insurance or guarantee by a third party with respect to the payment of interest and principal is termed as wrapped security. The third-party may be the parent company of the issuer of the security or a bank or an insurance company. The guarantee is typically provided by an AAA-rated company or a bank.
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 getting a bank guarantee 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 in case the ABC Inc. defaults during the tenure of the bond. 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.
- Securities with a higher credit rating will be most favored by investors, and securities with a low credit rating will not be invested in.
- It creates ambiguity among investors since credit enhancement might depict a false image of an issuer who is actually 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.
This has been a guide to What is Credit Enhancement and its Definition. Here we discuss the types of credit enhancement, including internal and external enhancement along with advantages and disadvantages. You can learn more about Credit Analysis from the following articles –