Letter of Credit

Summary

A letter of credit is a credit enhancement used by a government to secure a higher rating for its bond issues. It is typically a contractual agreement between a major bank and the issuing government consisting of an unconditional pledge of the bank's credit to make principal and interest payments of a specified amount on an issuer's debt for a specified period of time.

Advantages

• The primary advantage for the issuer is an improved credit rating on the issue. Letter of credit-backed issues are rated according to the bank's pledge to pay. As a result of obtaining a better rating, the issue usually will carry a lower interest cost.
• A letter of credit is a tool which greatly simplifies an otherwise complicated security arrangement so that investors can understand and evaluate the risks involved. This is particularly important as small, individual investors grow as a percentage of the investment market.
• A letter of credit also can be used to provide liquidity for commercial paper or variable rate demand bonds.

Disadvantages

• Issuers must pay a fee to obtain a letter of credit and also must pay interest if the letter of credit is drawn on. Unless the savings from the higher credit rating exceed costs associated with the letter of credit, this form of credit enhancement is not advantageous.
• Because banks issue letters of credit for periods shorter than the life of the bonds, the letters of credit must be renewed or replaced every three to five years over the life of the debt.
• Under certain conditions, banks may require the issuer to accelerate its repayment of the debt.
• Issuers may have difficulty finding a bank willing to issue a letter of credit. A shortage of domestic banks in this market with strong ratings has been reported.

Letter of Credit

Letters of credit are financial instruments used by a government to substitute the credit risk of the provider of the letter of credit, usually a bank, for that of the weaker debt issuer. Because the issue's rating is based on the bank's pledge to pay, issuers utilizing letters of credit are able to obtain more favorable interest rates on their issues than they would if their own creditworthiness were the basis for the rating.

A letter of credit is an unconditional pledge of the bank's credit to make principal and interest payments of a specified amount on an issuer's debt for a specified time period. It is an agreement to honor demands for payment upon compliance with conditions established in the agreement. Bank letters of credit also may be used to provide liquidity for commercial paper and demand bonds.

If the savings from obtaining a lower interest rate are greater than the costs associated with obtaining the letter of credit, and alternative, cheaper forms of credit substitution are unavailable, sound fiscal management suggests backing the issue with a letter of credit.

Types of Letters of Credit

There are two main types of letters of credit: direct pay and standby.

• A direct pay letter of credit provides that all debt service payments will be paid by drawing on the letter of credit.
• A standby letter of credit stipulates that the issuer has primary responsibility for making debt service payments, and that the letter of credit may be drawn upon only in the event of issuer default.

Nearly all letters of credit of both types are irrevocable, meaning that they constitute a direct guarantee by the bank, regardless of subsequent actions by the issuer. In exchange for payment of fees by the debt issuer, the bank promises to pay to the bond trustees an amount up to full principal of the debt issue, plus a specified amount of interest.

Banks impose two charges on issuers for letters of credit: commitment fees and draw-down fees. The commitment fee, a one-time payment at the time of the issue, usually ranges from 1/4 percent to 1 percent of the amount of debt. The draw-down rate is the interest rate the bank charges in the future if the letter of credit is actually drawn on. Banks usually charge their prime rate plus 1 percent on loans drawn under the letter of credit.

Risks

The primary risk associated with letters of credit stems from the fact that they are issued for terms shorter than the life of the debt. Letters of credit are typically granted for terms of three to five years, necessitating that the letter of credit be reinstated, or that another form of credit support be secured, several times over the life of the debt.

If the issuer is unable to obtain a replacement letter of credit, a mandatory redemption or tender of the debt will follow. In this scenario, if the issuer must draw on the letter of credit to pay bondholders, the issuer will then owe the entire amount of the debt issue to the bank, and interest will accrue at non-tax-exempt rates.