Use of Credit Enhancements in Money Market Funds

Credit enhancements involve the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender or the investor as is the case with a money market fund with reassurance that it will be compensated if the issuer defaults.  Credit enhancement occurs when a security’s credit quality is raised above that of the sponsor’s unsecured debt or that of the underlying asset pool.  A variety of internal and external credit supports are utilized to increase the likelihood that investors will receive the cash flows to which they are entitled. 

With an elevated level of turmoil in the municipal note and bond market, credit enhancements are in greater demand to secure liquidity and credit in municipal bond and note issuances.  In 2008, the complete breakdown in the auction rate market brought the need for credit enhancements into greater light.  The credit enhancements aid the municipalities or issuers of the notes and bonds in securing funds by reducing the perceived risk of these securities.  Without the enhancements the interest rates on these securities would be much higher and may exclude their sale to certain investors that can purchase only highly rated debt, municipal or not.

Issuers of securities use credit enhancements to raise the credit rating of a security by backing it with the credit of a third party.  There are several techniques used to improve the credit rating of an asset-backed security or a municipal bond, generally to get an investment grade rating from a bond rating agency and to improve the marketability of the securities to investors.  Credit enhancements such as, bond insurance and bank letters of credit can help lower the risk of default, improve liquidity, and reduce the interest rate that issuers must pay. 

Bond insurance often provides for unconditionally guaranteeing the payment of principal and interest on the bond or note if the issuer of the bond or note defaults.  Generally, this guarantee improves the credit rating of the security being issued or sold, because insured bonds typically are rated based on the credit of the insurer rather than relying solely on the underlying credit of the issuer.  Tax-exempt money market funds often hold municipal money market securities insured by a bond insurance company.  Problems can arise when the bond insurer is regarded as substandard credit.  If the bond insurer has its credit downgraded the municipal notes or binds may not meet the guidelines for the money market fund holdings.  The money market fund will then determine whether it must sell the securities.

This entry was posted on Tuesday, January 6th, 2009 at 1:23 pm and is filed under Mutual Funds. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.