The Value of Credit Enhancements

Credit enhancements include such things as advance refundings, bond insurance, and letters of credit. When a bond is insured, it assumes the rating of the insurer, which usually means that it receives a AAA rating. The higher a bond is rated, the lower its coupon payment will be, so the main reason to purchase bond insurance is to cut issuer costs, though credit enhancements also mitigate liquidity risk.

Bond insurance can be purchased by either the issuer or the underwriter, and it is an agreement that the insurer will take on the obligation to pay investors their interest and principal on time if the issuer does not have the funds to cover the payments. If the issuer does default and the insurer steps in to provide payments, the issuer remains respon