2.3.2 Credit Enhancement and Liquidity Support
Credit enhancement involves the provision of additional security for debt through a credit facility that provides for the timely payment of debt service to investors whether or not the amounts are paid by the issuer. With credit enhancement, investors can look for payment to come from either the basic source of payment for the debt or from the credit enhancement provider. The credit enhancement provider assumes the credit risk on the debt and steps into essentially the same position as investors with respect to the need for covenants and remedies to protect its interests. The most common types of credit enhancement are letters of credit (for variable rate debt) and bond insurance (the fixed rate debt).
Credit enhancement can be helpful in the sale of “story bonds” (bonds with unusual or complex credit characteristics), as the story may be more easily told to or understood by a credit enhancement provider than to an investor. In a pool financing, where the debt is secured by the obligations of a diverse mix of borrowers, credit enhancement can “unify” or “homogenize” the credit in the minds of investors. Further, credit providers may sometimes require security provisions and issuer covenants that are less burdensome than would be required to sell the debt without credit enhancement.
Credit enhancement can be used to allow debt that would not be investment grade to achieve a higher rating or to allow good credits that are “unratable” (e.g., based on the value of real property assets) to be rated. On rare occasions, credit enhancement can be used to enhance debt that is not of investment grade quality, although in these cases the security provisions and covenants may be much more stringent than if the debt were sold as unrated debt.
Issuers primarily use credit enhancement to achieve debt service savings. With credit enhancement, an issuer’s debt can be rated based upon the credit rating of the credit enhancement provider. For fixed rate debt, although the underlying credit of the issuer is still of interest to investors, credit enhanced debt is more secure and more highly rated and can therefore be sold to investors with a lower interest rate. If, on a present value basis, the interest cost saved with credit enhancement is greater than the cost of obtaining the credit enhancement, the issuer enjoys a debt service savings.
Liquidity support involves an obligation by a liquidity support provider to provide amounts for the purchase of variable rate debt obligations that are tendered for purchase and are not remarketed. With liquidity support, investors can rely on the credit of the liquidity support provider for payment of the purchase price. Because liquidity support would otherwise become credit support, a provider of liquidity but not credit support is allowed to terminate its purchase obligation upon the occurrence of an issuer bankruptcy, a payment default, or certain other major adverse credit events. The most common type of liquidity support are letters of credit, lines of credit, and standby bond purchase agreements.
Although certain issuers may be able to issue variable rate debt without credit enhancement or liquidity support, liquidity support for variable rate debt is still the norm. Investors holding variable rate debt require a high degree of certainty (a highly rated “put”) and even issuers with large cash balances available to purchase non remarketed bonds rarely try to comply with the cash management restrictions necessary to avoid the need for liquidity support.
Reference: California Government Code Section 5922(c) provides: “In connection with, or incidental to, the issuance or carrying of bonds, … the state or a local government may enter into credit enhancement or liquidity agreements, with payment, interest rate, currency, security, default, remedy, and other terms and conditions as the state or the local government determines.”
This Code section provides public agencies broad statutory authority to enter into credit enhancement and liquidity agreements but does not relieve the issuer from complying with constitutional limitations. Public agency payment obligations for credit enhancement and liquidity agreements must be structured in a manner that does not violate state constitutional debt limits. See Section 1.2, Constitutional Debt Limit.