Fixed Income Fundamentals: Credit Enhancements and Covenants

​Credit enhancements are provisions that may be used to reduce the credit risk for the bond issuer. Covenants are clauses that specify rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing.
 
Internal factors for enhancements relies on structural features regarding priority of payment or value of collateral (subordination and overcollateralization). External factors for enhancements refers to guarantees received from a third party known as guarantors. Surety bond are regulated and rated by insurance companies that provide similar service as a bank guarantee. Letter of credit from financial institutions provides a credit line to reimburse any cash flow shortfalls from the assets backing.
 
Affirmative covenants enumerate what issuers are required to do where negative covenants enumerate what issuers are prohibited from doing. Affirmative covenants are administrative in nature where they typically do not impose additional costs to the issuer and do not materially constrain the issuer’s discretion. Negative covenants, however, are costly and do materially constrain the issuer’s potential business decisions. Examples include restrictions on debt, negative pledges (prevent more senior issuances), restrictions on prior claims, and distributions to shareholders, asset disposals, investments, and restrictions on M&A.