Types of Bonds

Collateralised Bonds-Securitisation, Structured Products and Covered Bonds

Asset-Backed Securities - Market Risks

Interest Rate Risk - As with all fixed-income securities, the prices of ABS fluctuate in response to changing interest rates in the general economy. When interest rates fall, prices rise, and vice versa. Prices of ABS with floating rates are, of course, much less affected, because the index against which the ABS rate adjusts reflects external interest-rate changes.

Some ABS are subject to another type of interest rate risk—the risk that a change in rates may influence the pace of prepayments of the underlying loans, which, in turn, affects yields. As a general rule nonmortgage consumer assets, including credit card receivables, auto loans, student loans and so on, are not highly sensitive to fluctuations in interest rates. Thus, ABS backed by such assets are not usually subject to prepayment acceleration due to declines in interest rates.

Early-Amortisation Risk - Most revolving ABS are subject to early-amortisation events—also known as payout events or early calls. A variety of developments, such as the following, may cause an early-amortisation event: insufficient payments by the underlying borrowers; insufficient excess spread; a rise in the default rate on the underlying loans above a specified level; a drop in available credit enhancements below a specified level; and bankruptcy on the part of the sponsor or the servicer.

When an early-amortisation event is triggered, the revolving period is terminated, as is the controlled-amortisation period or the accumulation period, if applicable. Under early amortisation, all principal and interest payments on the underlying assets are used to pay the investors, typically on a monthly basis, regardless of the expected schedule for return of principal. Once early amortisation has been triggered, it cannot be rescinded or reversed. The accelerated repayment serves as a further protection for investors and, indeed, is required by the rating agencies.

Default Risk - The risk of default is most often thought of as a borrower’s failure to make timely interest and principal payments when due, but default may result from a borrower’s failure to meet other obligations as well. One such obligation critical in the ABS market is the maintenance of collateral as specified in the offer document.

As discussed above under “Credit Ratings”, one of an investor’s most reliable indicators of the likelihood of a security’s default is its credit rating. Because of the credit enhancements required for ABS by the rating agencies, the senior classes of most issues receive a triple-A, the highest rating available. The likelihood of failure to receive principal and interest payments for such securities is remote.

The B, C and any lower classes of an ABS issue are lower-rated or unrated and, indeed, are designed to absorb any losses before the senior tranche. Prospective buyers of these pieces of an issue must decide if the increased risk of default is balanced by the higher returns these classes pay.

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