Collateralised Bonds-Securitisation, Structured Products and Covered Bonds
Types of Bonds
Collateralised Bonds-Securitisation, Structured Products and Covered Bonds
Asset-Backed Securities – Key Investment Considerations
Interest Rates and Yields on Securitisations
Yield - As with any fixed-income securities, the yield on ABS depends on the purchase price in relation to the interest rate (which may be fixed or floating) and the length of time the principal is outstanding. But with ABS, prepayment assumptions must be taken into account in determining the likely yield of a given issue. The more realistic the prepayment projections, the more accurate the yield estimates.
New issues of ABS carry higher estimated yields than European government bonds, US Treasury securities and many corporate bonds of comparable maturity and credit quality. A key reason is that investors demand a higher interest rate to compensate for prepayment risk and resulting uncertainty in the average life of an ABS.
Once securities are trading in the secondary market, the spreads between ABS and Gilts, Treasuries or comparable corporate bonds may widen or narrow depending on market conditions, including the direction of interest rates in the economy, the number of issues coming to market and factors specific to each type of ABS. For example, a rising level of personal bankruptcies may cause the perception of risk in credit card ABS to increase, requiring higher yields to entice investors.
Average Life - Also called the weighted average life, this is the time-weighted average maturity of a stream of principal cash flows. As noted above, it is the usual time dimension cited in the selling and trading of amortising ABS. Average life can readily be estimated for a security that pays principal in a single payment. For an amortising structure, the average life varies, depending on the prepayment assumptions. Based on the structure of a particular ABS and the type of underlying collateral used, ABS “tranches”—separate classes of securities—may be created with average lives that correspond to the maturity and duration requirements of a broad range of investors—from short-term money market tranches to long-term assets.
Total Return - This is the overall return on an investment, usually calculated on a one-year basis, when all interest, principal payments, reinvestment income and any capital gains or losses are factored in.
Credit Quality and Credit Enhancement - ABS are generally rated by one or more of the following rating agencies: Standard & Poor’s Rating Services, Moody’s Investors Service and Fitch Ratings. These agencies determine the amount of credit enhancement required to produce a credit quality comparable to that of a same-rated corporate bond. The vast majority of ABS are issued in one of the top two generic credit rating categories, either triple-A or double-A.
The agencies’ determination of the required credit enhancement is based on the characteristics of the collateral and its performance under severe stress—specifically, under hypothetical “depression” scenarios. Beyond the overall credit risks of the asset pool, the agencies look at risks specific to ABS. For example, they make sure the payment rate on the underlying loans is fast enough to make either controlled amortisation payments as scheduled or a “bullet” payment.
Learn more through Standard & Poor’s publication on the Fundamentals of Structured Finance Ratings.
Special-Purpose Vehicle and the Rating - Use of an SPV is critical to the creation of ABS, because the SPV stands between the sponsor of the underlying loans and the issuer (the trust) of the securities. The key structural feature of an SPV, which enables it to insulate the trust from the sponsor, is bankruptcy remoteness. This is normally achieved by a “true sale” of the loans to the SPV by the sponsor. This means that the sponsor no longer has ownership rights to the loans, such that a trustee in bankruptcy of the sponsor would be unable to recover the loans or their proceeds. As a result, the ABS-issuing vehicle’s ability to pay interest and principal should remain intact even if the sponsor were to fail.
Bankruptcy remoteness, along with certain other aspects of the SPV’s structures and the extra support provided by credit enhancement, enable the ABS to receive their own credit rating, independent of that of their sponsor. This is important for investors, because the sponsor may well have a lower credit rating than the triple-A carried by the most senior tranches of most ABS.
Credit Enhancement - A distinctive feature of ABS is that they are credit-enhanced, unlike conventional corporate bonds, which are usually unsecured. 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/or external credit supports are employed to increase the likelihood that investors will receive the cash flows to which they are entitled. A distinction can be made between ‘internal credit enhancement’ and ‘external credit enhancement’ facilities.
Internal Credit Enhancement - Subordination: A popular type of internal credit support is the senior/subordinated (or A/B) structure, which is technically a form of “overcollateralisation.” It is characterised by a senior (or A) class of securities and one or more subordinated (B, C, etc.) classes that function as the protective layers for the A tranche. If a loan in the pool defaults, any loss thus incurred is absorbed by the subordinated securities. The A tranche is unaffected unless losses exceed the amount of the subordinated tranches.
The senior securities are the portion of the ABS issue that is typically rated triple-A, while the lower-quality (but presumably higher-yielding) subordinated classes receive a lower rating or are unrated.
Overcollateralisation - In this case, the face amount of the loan portfolio is larger than the security it backs.
External Credit Enhancement - In addition to internal credit supports, some ABS use external credit enhancement from a third party such as a monoline insurance or surety company.
A surety bond is an insurance policy provided by a rated and regulated insurance company to reimburse the ABS for any losses incurred. Often the insurer provides its guarantees only to securities already of at least investment-grade quality (that is, BBB/Baa or higher). Usually this requires one or more levels of credit enhancement that will cover losses before the insurance policy. An insured ABS is rated equal to the claims-paying rating of the insurance company, typically triple-A, because the insurance company guarantees the timely payment of principal and interest on the security. Certain but not all of the monoline insurance companies have been downgraded during the market turmoil of 2007-2008.
Third-Party or Parental Guarantees - A third party—e.g. a rated and regulated insurer, or the parent company of the seller/servicer—promises to reimburse a trust for losses up to a stated maximum Euro amount. They can also agree to advance principal and interest as necessary and buy back defaulted loans.
With a Letter of Credit (LOC), a financial institution, typically a bank, is paid a fee to stand by with cash to reimburse the trust for any losses actually incurred, up to the required credit-enhancement amount. These three forms of external credit enhancement expose the investor to “third-party risk,” where the ABS rating will be dependent on the creditworthiness of the institution providing the enhancement. If the institution is downgraded, then the ABS may also be downgraded.