Credit enhancement

Every lender asks the same question: will I be paid back? Credit enhancement is the issuer's way of giving a better answer than its own balance sheet can.

The workbook calls it a strategy to show the investors that the company would be able to pay back the borrowings as there is some kind of guaranteed system in place to support the borrowings — a method whereby a borrower or a bond issuer attempts to improve the credit worthiness of its debt offering.

The reassurance comes from outside the borrower's promise alone: an additional collateral, insurance, or a third party guarantee. And the workbook spells out three results: the company lowers its cost of borrowing, the bond gets a better rating grade, and the risk for investors is reduced.

The three forms the workbook names:

Why it moves price. In the debt market, pricing and returns for non-government debt instruments are dictated by the issuer's creditworthiness — its continuing ability to service the debt. A credit rating agency summarises that into a letter grade, from AAA for the highest quality down to high-risk "junk" or "high-yield" bonds, and the rating impacts the market price of the bond in both primary and secondary markets. The difference between corporate and government bond yields is the credit spread, the price of credit risk. Improve the grade, and the spread the issuer must pay narrows.

Related structures in the same chapter:

• Secured bonds are backed by specific assets and paid first out of them, giving a higher recovery rate.
• Asset linked bonds are issued giving better credit enhancement to investors; their payment capability depends on the underlying asset's performance.
• Securitised debt transfers loans and receivables to a Special Purpose Vehicle that issues tradable bonds against the pool.

None of these changes what the issuer is; they change what the bondholder can fall back on.

Illustrative issuer, ratings and coupons.

A mid-sized NBFC wants to raise Rs 200 crore through a 5-year bond. On its own standing, its rating would be A, and investors would demand a coupon of 9.75 percent.

Its parent — a larger, stronger group company — provides a third-party guarantee covering the bond. The rating agency assesses the enhanced structure and assigns AA. Investors now accept 9.00 percent.

Over five years that is Rs 7.5 crore of interest the NBFC does not pay — exactly the "lower cost of borrowing" the workbook describes.

The investor has accepted a lower coupon, but in exchange holds a bond with two sources of repayment instead of one. If the NBFC fails, the guarantor is called on.

Chapter 1 (Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets) covers credit enhanced bonds in section 1.3.5.3, alongside secured and unsecured debt, and mentions asset linked bonds as offering better credit enhancement in section 1.3.7. Section 1.14.5 on credit rating agencies and the chapter's sample questions on ratings and credit spread supply the pricing link. Expect a question on the forms of credit enhancement and its three effects.

• The three forms are additional collateral, insurance and third-party guarantee.
• The effects are lower borrowing cost, a better rating grade and lower investor risk — all three.
• Credit enhancement improves the debt offering's creditworthiness, not the issuer's own balance sheet.
• Higher rating means lower coupon. A bond with a higher credit rating pays lower interest, not higher.
• Credit spread is the price of credit risk, not of reinvestment or price risk — a Chapter 1 sample question.
• Secured and credit-enhanced are related but not identical. Security is one way to enhance; insurance and guarantees are others.