Appendix II: ABS payment structures.
Securities that return total principal to investors throughout the life of the security are considered fully amortising, where the securitised portfolio generally consists of assets, such as car loans, manufactured housing contracts or other fully amortising assets. Controlling prepayment risk is the prime concern with ABS structures of this kind, although the rate of prepayment may vary considerably by the type of asset.
Securitisation of non-amortising assets in the reference portfolio, i.e. revolving debt (such as credit card receivables, trade receivables, dealer floor-plan loans and some leases), typically sports a controlled amortisation structure with a relatively predictable repayment schedule in the bid to curb investor fears about the inherent risk of early amortisation in this kind of ABS. In controlled amortisation an ABS tranche is paid off in equal payments over a set period of time (often one or two years). Similar to corporate bonds with a sinking fund, the principal is repaid to investors over a period of less than a year after a contractually predetermined revolving period, when only defined interest payments occur (The Bond Market Association, 1998).
So-called bullet structures are a viable alternative to controlled amortisation structures for revolving assets. They are designed to return principal to investors in a single payment. Similar to controlled amortisation transactions, bullet payment structures feature two separate cash flow management periods. During the revolving period principal received from the reference portfolio is retained to buy more receivables, before the principal payments build up in an escrow account during the subsequent accumulation period to fund a future bullet payment to investors. As much as in controlled amortisation structures "bullet maturities" suffer from early amortisation risk. We distinguish between soft bullet maturity and hard bullet maturity. The former structure is the most common bullet structure, where only part of the deal is guaranteed on the expected maturity date (unlike the hard bullet deal), although past evidence indicates that most such ABS return principal on this date. Nonetheless, a soft bullet payment includes the implicit shortfall risk during the accumulation period, so that investors may receive the remaining principal payments over an additional period (usually one to three years) after the maturity date (Fabozzi and Yuen, 1998). In contrast, investors in hard bullet structures can expect principal to be paid off on the scheduled maturity date. This is usually done by providing for a longer accumulation period, a third-party guarantee, or both (The Bond Market Association, 1998). The latter bullet structure are rare, as investors in ABS are comfortable with limited repayment risk, and, hence, less inclined to pay the safety premium (i.e. accept lower yield) associated with the guarantee of timely repayment of principal.
Sequential pay is another alternative payment structure of ABS, where the issuer allocates all available principal repayments to the tranche with the shortest maturity until it is retired before the next tranche receives any principal. The diametrically opposite structure to this maturity-induced principal allocation is so-called pro rata pay. Here, payment is made concurrently to all tranches in accordance with their proportionate shares of principal payments during the life of the securities. According to Fabozzi and Jacob (1998) as well as Fabozzi and Yuen (1998) both sequential pay and pro-rata pay are also combined to address investor concerns about timely payment either upon credit-related events (switch from pro rata pay to sequential pay) or at a certain remaining maturity (switch from sequential pay to pro rata pay). At the same time issues with sequential pay represent a sizeable portion of the ABS market, mainly because the credit-enhancing effect of the senior/subordination structure allows the senior class of securities to be supported by one or more subordinated tranches. The degree of credit support is contingent upon the order of payment under subordination, which is determined once the junior classes of securities are issued (The Bond Market Association, 1998).
With the presence of floating-rate loans in underlying reference portfolios increasing, a growing number of issues--be they collateralised by either amortising or non-amortising assets--feature floating rather than fixed interest rates imposed on the ABS payment structure. This arrangement forestalls inevitable cash-flow mismatch between borrowers and investors if a reference portfolio of floating-rate loans, such as credit card debt indexed to the prime rate, is securitised through fixed-rate coupons on the ABS structure and vice versa. Hence, so-called floaters represent maturity structures of ABS with floating-rate coupons, where the rate adjusts periodically according to a designated index, usually the LIBOR rate or the U.S. Treasury Bill rate, plus a fixed margin. Alternatively, in the case of cash flow mismatch the issuing trust frequently engages in a counterparty interest rate swap or with an outside provider for a rate cap in the move to offset the basic interest rate risk to investors (Giddy, 2001).
Andreas A. Jobst
London School of Economics and Political Science (LSE) and J.W. Goethe Universitat Frankfurt am Main
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|Title Annotation:||Collateralised Loan Obligations (CLOs)--A Primer; asset backed securities|
|Author:||Jobst, Andreas A.|
|Publication:||The Securitization Conduit|
|Date:||Mar 22, 2003|
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