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Types of Bonds
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Asset Backed Securities (ABS)

Asset backed securities are bonds or notes backed by specific assets. They are created when companies take the cash flows from illiquid assets, (in most cases receivables), turn them into marketable securities, and sell the securities to a third party for cash. The receivables and associated debt are normally transferred to an off-balance sheet (bankruptcy protected) subsidiary. The originating company usually continues to collect the receivables, and forwards the interest and principle payments, when collected, to the buyer. Some of the newer type structures, in order to extend the average life of the transaction, and lower the overall cost, allow for additional receivables to be added to the credit facility and sold.

While the process has become routine, the concepts are very sophisticated. I view the process as “slicing and dicing” the cash flow streams of any assets, into a number of ways, then discounting those streams at market rates, and selling them to investors.

The typical, non-mortgage asset classes are: auto loans, credit cards, home-equity loans, insurance premiums, leases, student loans, and other installment sales contracts. The big institutional investors are the insurance companies and banks. They need to match their cash inflows from their investment portfolios to their pension and life insurance obligations as they come due. That said, pension and life insurance funds are fiduciary monies, and need to be invested in investment grade securities.

In order to achieve an investment grade rating by the major rating agencies, a credit enhancement (protection against default) is needed to ensure that cash flows will be available to pay the note holders. Getting an investment grade rating is more then substantiating the collectability of the assets. The rating agencies need to evaluate the underwriting standards, contracts, legal structure and the servicing capabilities. There are a number of different credit enhancement techniques used to convert a risky cash flow stream into a creditworthy one.

The main types of credit enhancements are:

·        Cash collateral accounts

·        Credit risk reserve accounts

·        Over collateralization

·        Subordination tranches

·        Substitution of defaulted collateral with good collateral

·        Irrevocable letter of credit

·        Insurance policy – surety bond

·        Residuals

·        Cross collateralization with the parent or sister company

·        Sequential-pay securities

Credit enhancements insure note holders will be paid.

While non-mortgage asset backed securities are primarily private place deals, more are now becoming public. 

Don’t consider prepayments to be a risk; getting paid back is always a good thing. Prepayments are part of the business; in most cases they are relatively predictable.

Structures are customer driven, and features include: interest only, full amortization, non-amortization loans and bullet structures. Fixed and floating rates are also available.

These are solid investments! Be comfortable with the issuer / servicer, because maintenance of the underlying assets, at a profitable level, is complicated. Preparing the servicing reports is difficult. Realize that the monthly payments received by the investors consist of interest, return of scheduled principle payments and prepayments.

Regarding young adults, I view asset backed securities more for those investors looking for steady cash flow streams.


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