The use of the credit of an entity having greater financial strength than the issuer or borrower to improve the credit quality of a bond issue.
Credit Enhancement or Liquidity Facility Provider
Parties providing superior credit to improve the credit quality of a Bond Issue, and/or funds to the Issuer to make repurchase Bonds that a bondholder has Tendered. Credit Enhancement provides an additional source of repayment for the Bonds if the expected source of repayment (for example, revenues produced by the project that is financed by the Bonds) may be less than sufficient to pay the Principal and Interest on the Bonds when it is due, or if the credit strength of the underlying Security is low. Credit Enhancement can take the form of Bond Insurance, a line of credit, a surety bond, a Guaranty or a Letter of Credit. Generally, Credit Enhancement raises the Rating on the Bonds, which reduces the Interest Rate on the Bonds because it provides the bondholders with additional comfort as to the repayment of the Debt Service on the Bonds. However, not all Credit Enhancement provides the same level of Security to bondholders. As an example, a Guaranty might provide a guarantee from a party other than the Issuer to repay only a portion of the Principal and Interest on the Bonds if the Issuer is unable to do so, while a Bond Insurance Policy might guarantee the repayment of both Principal and Interest on the Bonds if the Issuer is unable to make those payments.
In addition to obtaining Credit Enhancement, a liquidity facility or a Standby Bond Purchase Agreement may also be obtained by an Issuer to provide the Issuer with funds on short notice to permit it to purchase the Bonds it has previously issued if the holders of the Bonds Tender them to the Issuer prior to the Maturity Date. Bondholders will often have these Tender rights in the case of Bonds bearing a Variable Interest Rate or that are Commercial Paper. If the bondholders Tender their Bonds to the Issuer earlier than the Issuer anticipates, the Issuer is required to buy them back from the bondholders, but it may not have money to make that purchase. The provider of the liquidity facility will provide the funds to the Issuer to make the purchase, and the Issuer will then be obligated to repay the provider of the liquidity facility once the Issuer has money from the resale of the Bonds or from other sources to repay such provider.
Life’s a Party
Learn more about the various parties involved in a municipal securities transaction and their roles.