Credit enhancement
Asset-Backed Securities glossary · Tranching & Structural Mechanics
Definition
Structural or external features that protect senior bondholders from losses on underlying collateral.
Credit enhancement in plain English
When investors buy bonds backed by a pool of loans, some of those loans will inevitably go bad. Credit enhancement is any built-in safety cushion that soaks up those losses BEFORE they reach the safest ("senior") investors, so those investors almost always get paid in full. It can come from inside the deal (like putting riskier investors first in line to absorb losses, or collecting extra cash into a reserve account) or from outside (like an insurance guarantee). Think of a stadium with the cheap seats up front getting rained on first — the expensive covered seats stay dry, and that protection is exactly why people pay more for them.
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