Types of Bonds
Collateralised Bonds-Securitisation, Structured Products and Covered Bonds
How are ABS Structured?
Soft/Hard Bullet - “Bullet” structures, which are also used with revolving assets, are designed to return principal to investors in a single payment. These ABS also feature two separate cash-flow management periods: the revolving period, during which any principal repaid is used to buy more receivables, and the accumulation period (analogous to the amortisation period in a controlled-amortisation structure), during which principal payments build up in an escrow account to fund the bullet payment to investors.
The most common bullet structure is the soft bullet, so labelled because the bullet payment is not guaranteed on the expected maturity date (although most such ABS do pay off on time). UK master trusts frequently issue soft bullet maturity securitisations. The potential for a shortfall exists during the accumulation period, in which case investors may receive the remaining principal payments over an additional period (usually one to three years) until what is known as the final maturity date.
In contrast, a hard-bullet structure ensures that the principal is paid on the expected maturity date and does this with a longer accumulation period, a third-party guarantee or both. In a hard bullet, rating agencies evaluate the timeliness of principal payments. Hard bullets are rare, because investors are comfortable with soft bullets and are unwilling to pay extra (in the form of a lower yield) for a guarantee. As with controlled-amortisation structures, soft- or hard-bullet structures are also subject to early amortisation risk.
Floating Rate - In Europe, most securitisations are floating rate. The rate adjusts periodically according to a designated index (such as LIBOR or Euribor) plus a fixed margin.
When the underlying collateral is itself made up of floating-rate loans—such as credit card debt indexed to the prime rate—a floating-rate coupon on the ABS can help avoid a cash-flow mismatch between the borrowers and the investors. When the collateral consists of fixed-rate loans, a cash-flow mismatch is inevitable. Therefore, the issuing trust often arranges with a counterparty for an interest rate swap or with an outside provider for a rate cap to offset the resulting basis risk to investors.
Sequential Pay - Frequently, ABS are issued as sequential-pay securities. This means that the first tranche (the one with the shortest average life) receives all available principal payments until it is retired; only then does the second tranche begin to receive principal; and so on. (The alternative structure is pro rata pay, under which all tranches receive their proportionate shares of principal payments during the life of the securities. A combination of these is also very common: sequential deals which switch to pro rata at a certain date or pro rata deals which switch to sequential upon credit-related events.)
As stated above, one of the main ways ABS are credit-enhanced is with a senior/subordinated structure, in which a senior class of securities is supported by one or more tranches of subordinated securities. The order in which investors in the subordinated ABS are paid is determined by the payment rights and priorities that are established when the junior classes are issued.
Prepayment Models - Investors in ABS are typically concerned about the likelihood and extent of prepayment. That is, they worry about receiving all or part of the principal of the underlying debt before it is due (in the case of amortising assets) or before it is expected (in the case of nonamortising assets). Determining the most likely prepayment scenario is critical to making an investment decision with a reasonable expectation about a security’s life—which, in turn, affects the likely yield.
Unlike in the US, where most residential mortgages are prepayable at no penalty, in Europe, many mortgages have prepayment penalties. These can differ significantly from country to country. In many cases, European mortgages are fixed rate for a certain time period, and then convert to floating rate. If these types of mortgages are included in an RMBS, usually there will be included in the structure an interest rate swap to convert the fixed rate payments to floating rate, so investors receive just a floating rate. Since most RMBS are floating rate, prepayment has a lower impact on yields than in the US.
What follows are explanations of the key prepayment conventions used by the ABS market. Investors should bear in mind that prepayment models do not predict actual prepayment behaviour, but instead provide a common methodology for expressing prepayment activity.
Constant Prepayment Rate (CPR) - The CPR (also known as conditional prepayment rate) measures prepayments as a percentage of the current outstanding loan balance. It is always expressed as a compound annual rate—a 10% CPR means that 10% of the pool’s current loan balance pool is likely to prepay over the next year.
Monthly Payment Rate (MPR) - Technically, this is not a prepayment measure, because it is used with nonamortising assets, such as credit card and other receivables, which are not subject to prepayment. Rather, the MPR is a repayment measure and is calculated by dividing the sum of the interest and principal payments received in a month by the outstanding balance. The rating agencies require every nonamortising ABS issue to establish a minimum MPR as an early-amortisation trigger event; if repayments drop to that level, the security enters into early amortisation. Early amortisation means that payment of the bond principal in an asset-backed security is accelerated.
Absolute Prepayment Speed (ABS) - This abbreviation (which, confusingly, is the same as that used for asset-backed securities) is commonly applied to securities backed by auto loans, truck loans and auto leases. Unlike CPR, which measures prepayments as a percentage of the current outstanding loan balance, the ABS calculates them as a monthly percentage of the original loan balance.
Asset-Backed Versus Other Fixed-Income Securities - Amortising ABS, like mortgage-backed securities, are generally sold and traded according to their “average life” rather than their stated maturity dates, as with corporate and government bonds. Average life, as described under “Interest Rates and Yields on ABS”, is the average length of time that each principal Euro in a pool is expected to be outstanding.
Although ABS are less familiar to some investors, the cash-flow characteristics of these securities often mirror those of MBS—which is not surprising: Mortgages were the first assets to be securitised, and they have become very familiar to investors. Less commonly, ABS may have cash flows that resemble those of corporate bonds.