Securitised credit enhancement: Credit where it’s due

The process of securitisation is not ‘investment alchemy’ in which low-quality credit assets ‘magically’ transform into  higher-quality assets. Instead, it’s a risk transfer technique that seeks to mitigate losses in stressed scenarios for  risk-adverse investors holding senior tranches. 

Types of credit enhancement

The core principle of credit enhancement is that it builds more financial backing into certain tranches of a security  than would otherwise be the case. The main types of credit enhancements are: 

Subordination: This is the process of dividing up and sharing losses. Junior bond holders in the securitisation structure absorb losses from defaults on the underlying loans first, helping to protect senior  bonds. Subordination means that lower-rated junior bonds serve as credit support for the higher-rated senior bonds.

Over collateralisation: This is the process of providing collateral that exceeds the value of the loan or  security when issued. This excess collateral acts as a buffer against potential losses for the bondholder. For the issuer of the securitised asset, the potential benefit is that it can lead to higher credit quality and  more favourable borrowing terms.

Excess spread: This refers to the difference between the interest received on the underlying collateral (such as such as a mortgage interest rate) and the interest paid on the securities. The excess spread can then be used to absorb losses or build over collateralisation to its target level

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The value of an investment and any income taken from it is not guaranteed and can go down as well as up, and the investor may get back less than the original amount invested. Past performance is not a guide to future performance.