Credit enhancement encompasses a variety of provisions that may be used to reduce the credit risk of an obligation. Credit enhancements are often incorporated into OTC derivatives, corporate debt, securitized debt and other instruments. Techniques of credit enhancement include:

  • collateralization: One or more parties may agree to post collateral. Collateral levels may be fixed or vary over time to reflect the market value of different parties’ obligations.
  • third party loan guarantees: A parent company or other third party may be contractually bound to meet the obligations of one party should that party default.
  • credit insurance: An insurance policy may provide for compensation in the event that a party defaults.
  • letters of credit: A bank may confirm financing.
  • special purpose vehicle: One party may enter into the deal through its own over-capitalized, bankruptcy remote subsidiary.

Other techniques may sometimes also be referred to as credit enhancement. These include netting agreements, credit downgrade triggers, and bundling with credit derivatives.