Reading 64: Asset-Back Securities (ABS) Instrument and Market Features

Book 3: Fixed Income

Covered Bonds

senior debt obligations of financial institutions that are similar to ABS

What is different about Covered Bonds compared to ABS?

Covered Bonds

• stay on the balance sheet

• no SPE is created

• Issued primarily in Europe, Asia, and Australia

• Lower yield than ABS

• No credit trancheing usually

• issuer has to replace nonperforming assets in the covered pool

Dual Recourse

in the event of an issuer default, investors have a claim on the collateralized assets’ cash flows and assets not pledged by the originator

Unencumbered Assets

assets that were no pledged in a collateral agreement

Overcollateralization

to mitigate the credit risk for ABS investors, the collateral is greater than the face value of the covered bonds

Hard-Bullet Covered Bonds

a covered bond becomes in default if the issuer fails to make a scheduled payment, leading to the acceleration of payments to covered bondholders

Soft-Bullet Covered Bond

postpones the originally scheduled maturity date of a payment if it is missed

up to a year

Conditional Pass-Through Covered Bond

converts to a pass-through bond on the maturity date if any payments remain due

Types of credit enhancement structures

overcollateralization

excess spread

credit tranching

Excess Spread

builds up reserves in the ABS structure by earning higher income on the collateral than the coupon promises

Credit Tranching

ABS is structured with multiple asset classes of securities each with a different priority on claims

How much credit loss is an investor in a tranche exposed to?

just the principal amount

Equity Tranche

the lowest class that has a residual claim on any value left over

Credit-Card ABS

backed by pools of credit card debt

Do Credit Card ABS have an amortized or nonamortizing payment strucutre?

nonamortizing

people pay back credit in different ways

Lockout Period/Revolving Period

ABS investors only receive interest and fees paid on the collateral

the principal is not passed through to investors and is instead used to purchase more collateral (credit card receivables)

Amortization Period

after the lockout period, when principal is passed through to investors

Solar ABS

backed by loans to homeowners wishing to finance installation of solar energy systems

Prefunding Period

allows the trust to make investments in solar loans for a fixed period after raising funds through issuing ABS

What are solar loans secured against?

the solar system itself or the homeowner’s property as a junior mortgage

Collateralized Debt Obligations (CDOs)

structured security issued by an SPE for which the collateral is a pool of debt obligations

Collateralized Bond Obligations (CBOs)

CDOs where collateral securities are corporate EM debt

Collateralized Loan Obligations (CLOs)

supported by a portfolio of leveraged bank loans

Leveraged Loans

senior secured bank loans made to companies that have high levels of debt or are already in poor credit standing

Which is the most common type of CDO?

CLO

Cash Flow CLOs

payments to CLO investors are generated through the cash flows on the collateralized assets

Market Value CLO

payments are generated through trading the market value of the underlying collateral

Synthetic CLOs

collateral pool exposure is artificially recreated through credit derivative contracts

In which CLO does the trust not take full ownership of the collateral?

Synthetic CLOs

What is the main difference from ABS and CDOs?

collateral manager

CDOs don’t rely entirely on payments from the collateral pool

Collateral Manager

tasked with dynamically buying and selling securities in the collateral pool to generate cash to make payments to investors

Things that protect CDO investors from default

limitations on CCC rated debt

diversification

overcollateralization in every tranche

coverage of payment obligations