Fixed Income Types: Asset-Backed Securities

Asset-Backed Securities (ABS) Structure, Prepayment, Structuring, and Valuation

Asset-Backed Securities (ABS) are financial instruments that represent ownership in a pool of underlying assets, such as loans, leases, or receivables. ABS allow originators of these assets, such as banks or financial institutions, to transform illiquid assets into tradable securities. In this section, we will explore the detailed aspects of ABS, including their structure, prepayment considerations, structuring techniques, and valuation methods, with the inclusion of mathematical examples.

I. ABS Structure

ABS are created through the following steps:

1. Asset Pool Creation: Originators aggregate a pool of homogeneous or heterogeneous assets, such as auto loans, credit card receivables, or student loans. The assets in the pool share similar characteristics, such as credit quality, maturity, or underlying collateral.

2. Special Purpose Vehicle (SPV) Formation: An SPV is established to hold the assets in the pool. The SPV is a bankruptcy-remote entity that issues the ABS.

3. Structuring the ABS: The pool of assets is divided into different tranches based on risk and return preferences. Each tranche represents a distinct portion of the cash flows generated by the underlying assets and carries a specific level of risk and priority in receiving payments.

4. Issuance and Distribution: The ABS tranches are sold to investors through underwriters or investment banks. Investors receive cash flows from the ABS based on the tranche they hold.

II. Prepayment Considerations

Prepayment risk is a critical consideration for ABS investors. Prepayments occur when borrowers repay their loans or obligations earlier than their scheduled due dates. The impact of prepayments on ABS cash flows depends on the type of underlying assets and the prepayment behavior of borrowers.

Example

Consider an ABS backed by a pool of auto loans. If interest rates decline, some borrowers may choose to refinance their loans at lower rates, resulting in prepayments. The prepayments reduce the cash flows received by ABS investors, potentially affecting investment returns.

III. Structuring ABS

ABS can be structured using various techniques to tailor the risk and return characteristics to meet investor preferences. Common structuring techniques include:

1. Credit Enhancement: Credit enhancement measures, such as overcollateralization or reserve accounts, are employed to protect ABS investors from potential losses. Overcollateralization involves including more assets in the pool than the amount required to support the ABS issuance, providing a cushion against potential defaults.

2. Tranche Structure: ABS can have multiple tranches with different risk profiles. Senior tranches have the highest payment priority and offer lower yields but greater credit quality. Subordinate tranches have lower payment priority, potentially higher yields, but carry higher credit risk.

IV. ABS Valuation

Valuing ABS involves estimating the present value of expected cash flows from the underlying assets. Valuation models take into account factors such as prepayment risk, credit risk, and interest rate risk. Two common valuation approaches for ABS are the cash flow analysis and the option-adjusted spread (OAS) analysis.

1. Cash Flow Analysis: The cash flow analysis calculates the present value of expected cash flows using a discount rate that reflects the risk characteristics of the ABS. Cash flow projections consider principal and interest payments, prepayment assumptions, and defaults.

Example

Suppose an ABS is backed by a pool of credit card receivables. Cash flow analysis estimates the present value of future cash flows, incorporating prepayment assumptions based on historical data and expected default rates.

2. Option-Adjusted Spread (OAS) Analysis: OAS analysis incorporates option pricing models to estimate the spread required to compensate investors for the embedded options in ABS, such as prepayment and call options. OAS reflects the additional yield investors demand for bearing the uncertainty of prepayment behavior.

Example

Using OAS analysis, an investor can determine the spread over the risk-free rate that adequately compensates for the prepayment risk associated with an ABS backed by mortgage loans.

V. Mathematical Examples

1. Prepayment Calculation: Assume an ABS is backed by a pool of mortgage loans, and the prepayment rate is estimated to be 5% per year. If the outstanding balance of the mortgage loans is $10 million, the expected prepayment amount would be $500,000 per year (5% * $10 million).

2. Structuring Example: Consider an ABS with two tranches: a senior tranche with a payment priority and a junior tranche. The senior tranche has a face value of $50 million, and the junior tranche has a face value of $20 million. The cash flows from the underlying assets are first allocated to the senior tranche until it is fully paid off, and any remaining cash flows go to the junior tranche.

3. Valuation Example: Using cash flow analysis, an investor estimates the expected cash flows from an ABS backed by auto loans over a 5-year period. The expected cash flows for each year are $2 million, $2.5 million, $2.5 million, $3 million, and $3.5 million. Assuming a discount rate of 5%, the present value of these cash flows can be calculated to determine the ABS valuation.

Conclusion

Asset-Backed Securities (ABS) transform illiquid assets into tradable securities, offering investors exposure to cash flows from pools of underlying assets. Understanding the structure, prepayment considerations, structuring techniques, and valuation methods is essential for investors in the debt and money markets. A comprehensive understanding of ABS empowers investors to assess risk and make informed investment decisions in this segment of the market, including considering prepayment behavior, structuring options, and valuing ABS through cash flow analysis and option-adjusted spread analysis.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.