LeoGlossary: Credit Enhancement
In a credit enhancement, an issuer pays a third party to provide a “backup” source of funding for principal and interest payments on its bonds. This added guarantee reduces the risk that payments will not be made to bondholders, and thus allows the issuer to obtain a higher credit rating for its bonds. The new bond rating is based on the credit rating of the entity providing the enhancement, rather than the issuer.
Bond insurance is an example of a credit enhancement. Here an issuer buys a bond insurance policy from an insurance company, and in return, the insurance company agrees to pay interest and principal on the insured bonds if the issuer defaults. The insurance company’s claims-paying rating, analogous to a bond rating, is used for the bonds.
A letter of credit from a bank is another form of credit enhancement. In this case, a commercial bank makes an irrevocable commitment to pay principal and interest if the issuer cannot make payments. When the bonds are issued, the bank’s credit rating, rather than the issuer’s, is used.
General:
Posted Using LeoFinance Beta
