Internal and External Credit Enhancements

Which of the following statements _best describes_ the relationship between overcollateralization and excess spread?

Incorrect. It is conceivable an issue is overcollateralized at the time of issuance but does not generate enough income to back the payments to the bondholders in the future. Therefore, this relationship does not always exist.

Incorrect. Internal credit-enhancement mechanisms such as overcollateralization and excess spread can benefit both the senior and the junior debtholders. However, most benefits will be offered to the senior debtholders, since they have the priority of claims.

Correct! Since it is not possible to forecast the cash flows generated by the underlying assets accurately, the issuer may not fully benefit from excess spread at the time of issuance. On the other hand, if the collateral is more than what is needed, it will be obvious at the time of issuance. As a result, bond issuers benefit more from overcollateralization at that time in the form of a lower required yield.

An overcollateralization of a bond generates excess spread

Both factors benefit only the junior debt holders by lowering credit risk

Borrowers benefit more from overcollateralization than excess spread at the time of issuance