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Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies. Credit enhancement is of two types - External credit enhancements, and Internal credit enhancement.
External Credit Enhancement: It comes in the form of third-party guarantees like corporate guarantee, letter of credit, and bond insurance. The disadvantage of this mechanism is that it is based on the credit risk of the third party guarantor. If the third party guarantor feels downgraded then the issue would also be subjected to downgrade, even if the structure is giving expected performance. In other words, this mechanism places the investor to event risk because the downgrading of the third party guarantor may result in downgrading of the asset-backed securities.
Internal Credit Enhancement: It comes in the form of reserve funds, over collateralization, and senior/subordinate structures. This is a more complex form of mechanism when compared to that of external credit enhancement mechanism.
Optimal Portfolio Selection: The next step involves selecting the optimal portfolio. The strategic asset allocation will have overriding importance in pension fund management.
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