Credit Enhancements | CFA Level I

Credit enhancements are strategic measures to mitigate the credit risk associated with a bond issuance, making them a staple in the creation of Asset-Backed Securities (ABS).

Types of Credit Enhancements

Credit enhancements are categorized into internal and external mechanisms, each serving to bolster the appeal and safety of bond issues:

Internal Credit Enhancements

• Subordination (Credit Tranching): Divides bond issues into various tranches with differing seniority levels in claim rights, ensuring higher safety for senior tranche investors.
• Overcollateralization: Involves issuing debt secured by collateral whose value exceeds the debt’s par value, providing a cushion against potential losses.
• Reserve Accounts: Comprises cash reserves or excess spread accounts to cover shortfalls in asset yield versus bond obligations.

External Credit Enhancements

• Surety Bonds: Insurance company guarantees to cover any cash flow shortfalls.
• Bank Guarantees: Promises by banks to cover deficits in debt service payments.
• Letters of Credit: Commitments by banks to lend the shortfall amount to the bond issuer.

Understanding the Mechanisms

Let’s delve deeper into how these enhancements work:

• In subordination, the cash flow ‘waterfall’ prioritizes senior tranches over junior ones, thus allocating risk and returns differently across investors.
• Overcollateralization acts as a buffer, where the extra collateral value can absorb losses, ensuring bondholder protection.
• Reserve accounts, either through cash funds or excess cash flows, serve as a financial safety net for bond issues.

Benefits and Applications

Credit enhancements significantly improve the attractiveness of bond issues by:

• Reducing the perceived risk for investors.
• Potentially achieving higher credit ratings for the bond issue.
• Increasing marketability and reducing funding costs for issuers.

Through strategic application of these mechanisms, issuers can tailor their bond offerings to meet investor demand for safety, while optimizing financing costs.