What is Credit Enhancement?

Credit enhancement is any action taken to improve your 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

There are several advantages to engaging in credit enhancement activities, which are as follows:

Increased borrowing capability. By engaging in credit enhancement, an organization may be able to increase the amount it can borrow. This could be a key issue, if you can use the additional funds to expand your business and generate more income than the incremental amount of added interest expense.
Reduced interest rate. A credit enhancement may reduce the interest rate that you are 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.

Disadvantages of Credit Enhancement

Offsetting these advantages of credit enhancement 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.