Asset-Backed Securities: Structure

Most asset-backed securities (ABSs) are issued as separate tranches, or classes, of securities, which have different risks and yields. The highest tranche, frequently designated as class A, has the highest credit rating—usually triple-A—that is supported by junior tranches. An ABS will usually have 3 tranches—class A, B, and C. The B and C tranches pay a higher yield because they have a lower credit rating. Indeed, the class C tranche may not even have a credit rating and may not even be offered to the public. Instead, it is usually retained by the issuer or sponsor of the ABS. The lower tranches receive most or all of the losses, unless the losses are large, then the class A tranche will start to suffer some losses, also.

The senior tranche is, by far, the largest tranche, and ABSs are structured this way so that the senior tranche will have an investment grade rating, so that it can be sold to institutional investors, who are the main purchasers of ABSs, and who, in many cases, can only buy investment grade securities, especially securities that comply with ERISA.

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Some ABS structures use tranches that receive a pro rata share of the payments of principal. Many structures, however, are based on sequential pay tranches, where the highest tranche receives all of the payments of principal until all investors of the tranche have been paid off, then the next tranche receives the principal payments, then the next, and so on, until all investors have been paid. Investors of the lowest tranches are not likely to be fully repaid, however, and may suffer large losses. Sometimes, a tranche using a sequential pay method will switch to a pro rata distribution at a specified date, or tranches that were originally receiving pro rata distributions of principal may switch to a sequential pay distribution if a credit-related event occurs that may jeopardize the full repayment of the senior tranches.

How the principal is repaid depends on whether the ABS is based on amortizing debt or revolving debt. ABSs based on full amortization loans pay investors both principal and interest in each payment, since the loan payments of the underlying assets consists of both principal and interest.

ABSs based on revolving debt use controlled amortization to repay the principal, where, for a specified time, the ABS holder receives only interest, then in the final period, which is the controlled amortization period, the payments consists of the return of principal. If an early amortization trigger is activated, and the issuer is having difficulty paying the principal, then the controlled amortization period may be extended, sometimes for up to 3 years.

Soft and Hard Bullets—Paying the Principal in 1 Payment

Some ABSs pay the principal in 1 payment, which is known as a bullet structure. The ABS life cycle of a bullet structure consists of a revolving period, during which principal payments from the underlying portfolio are used to buy more receivables, and an accumulation period, when principal payments are paid into a fund that will be used to pay the final principal payment to ABS investors. All bullet structures are subject to early amortization triggers.

The bullet structure can be classified as a soft bullet or hard bullet. The soft bullet, the most common bullet structure, has a specified maturity period of 1 to 3 years. The soft bullet has an expected maturity date, which is the date on which the final principal payment is expected to be made, but is not guaranteed. If there is a shortfall in the accumulation phase, then the maturity phase could be extended all the way up to the final maturity date (aka legal maturity date), when all investors of the ABS issue must be paid in full. The soft bullet structure gives the issuer some flexibility, and pays a higher yield than the hard bullet ABS. In most cases, the final principal payment is made on the expected maturity date.

The hard bullet is structured so that the final principal payment is much more likely to be paid on the expected maturity date. This structure may consist of a longer accumulation phase or a 3rd party guarantee or both.