What is Credit Enhancement?

Credit enhancement is any action taken to improve one’s creditworthiness. For example, an issuer of bonds can obtain insurance or a surety bond from a third party that guarantees payment of the bonds. Other options are for the borrower to provide additional collateral to the lender, or to set aside cash in a sinking fund that is reserved for the eventual retirement of any bonds issued. Yet another possibility is to adopt a more conservative financial structure by keeping more cash on hand, thereby improving the liquidity ratios being examined by lenders.

Advantages of Credit Enhancement

By engaging in credit enhancement, an organization may be able to increase the amount it can borrow, as well as reduce the interest rate it is charged. For example, a bond issuer might be able to improve the rating on a bond issuance, allowing it to sell the bonds at a somewhat lower interest rate. Offsetting these advantages is the cost of the enhancement. For example, obtaining a surety bond to guarantee payment of a bond may very well reduce the interest rate on the bonds, but also introduces the cost of the surety bond. The net effect of these two items could be a worse expense situation for the business.