Credit Enhancement

Before a bond is issued, it is rated according to its creditworthiness. Private ratings services, such as Standard & Poor’s, Moody’s Investors Services, and Fitch Ratings, are hired by the issuing company to assess the financial strength of the company. Their evaluation of the company’s ability to pay a bond’s principal and interest in a timely fashion will determine the bond’s coupon rate. The higher the grade, the lower the coupon. Bond ratings are expressed as letters ranging from AAA to C. A triple-A rating is the most desirable, representing an investment-grade bond with a minimal credit risk. To be considered investment grade, a corporate bond must be rated a BBB or better. BB or below are considered non-investment grade. Each of the services uses the same basic grading system, with some variations in style.

Credit enhancement is a legally binding pledge of financial support from a source other than the issuer that virtually guarantees repayment of the bond and serves to improve the creditworthiness of the bond. Bonds with credit enhancements have higher credit ratings than comparable bonds without.

Bond insurance. An insurance covenant promises one form of credit enhancement through a bond insurance policy that is non-callable and covers the issuer’s debt service o