Credit enhancements are provisions that improve a bond’s credit quality and decrease its yield. They are of two types: (a) internal, those which are related to the structure of the bond, and (b) external, those which are based on external third-party guarantees.
Internal credit enhancements
Common internal credit enhancements include subordination, over-collateralization and reserve accounts.
Subordination (also called credit tranching) is the most popular and it involves creating different tranches of a bond each with different rank. In an event of default, the senior tranches are paid before any amount can be paid to the subordinated/junior tranches. This is also called a waterfall structure.
Over-collateralization occurs when a company provides more than the required collateral. The excess collateral provides a cushion to absorb losses if any. But the valuation of collateral offers a significant challenge because asset values may drop drastically during the financial crisis.
Reserve accounts/funds have two types: cash reserve fund and excess spread account. In a cash reserve fund, cash which is meant to absorb losses in the event of default is deposited; while in the excess spread account, the excess of cash flow proceeds from assets which back the bond over the bond interest payments are deposited in an account.
External credit enhancements
Common external credit enhancements include:
- Bank guarantees and surety bonds reimburse the bondholders for losses unto a maximum limit. Bank guarantees are issued by banks and surety bonds are issued by insurance companies.
- Letter of credit provides a credit line to the issuer to utilize in case of any shortfall of cash flows.
- Cash collateral account represents an actual cash deposit by the issuer to back the bond issue.
Surety bonds and letters of credit have become less popular since the financial crisis. Other than the cash collateral account have some level of counterparty risk.