The ABCs of Asset-Backed Securities (ABS)

Summary

Asset-backed securities (ABS) finance pools of familiar asset types, such as auto loans, aircraft leases, credit card receivables, mortgages, and business loans. In one way or another, these asset types represent contractual obligations to pay.

These contractual obligations to pay often rank senior to a borrower’s traditional debt obligations, reducing ABS investors’ exposure to the borrower’s financial health. ABS also have many other investor-friendly features that may help protect against loss and improve liquidity, such as tranching of risk, overcollateralization, and diversity of payers in each underlying pool. Despite these and other strengths discussed in this report, some ABS and other forms of structured credit continue to offer higher yields than similarly rated corporate or municipal bonds. ABS investors’ principal job is to analyze the cash flows from these obligations to assess value and the possibility of loss, rather than relying solely on the current market prices of hard assets, the reputation of a sponsor, or the presence of an investment-grade rating.

During the 2008 global financial crisis (GFC), many investors experienced losses related to certain private label residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and MBS-backed collateralized debt obligations (CDOs). In the aftermath of the crisis, the structured credit market underwent a painful yet necessary transformation as market participants returned to sustainable underwriting practices. However, the asset class remains complicated. At Guggenheim, we believe that identifying value and risk in ABS requires dedicated credit, trading, technology, and legal resources supporting a disciplined investment process.

Report Highlights

• Securitization begins with the creation of a special purpose vehicle (SPV) that acquires a pool of assets and simultaneously raises debt financing to fund the purchase of those assets through the issuance of ABS.
• Assets backing a securitization must include contractual obligations to pay. Each asset features a payer (borrower, lessee, insurer, etc.) and a contract (mortgage, lease, loan, account receivable, etc.). A securitization typically pools contractual assets of the same type (auto loans, aircraft leases, credit card receivables, corporate loans, etc.).
• ABS carry investor-friendly features intended to help protect against loss and improve liquidity, including bankruptcy remoteness, prioritization of payments, overcollateralization, excess spread, amortization, professional servicing, and diversity of payers within each underlying pool.
• Lenders, lessors, and specialty finance companies commonly turn to the structured credit market for funding. Additionally, traditional corporate borrowers that receive payments under contract may securitize those contracts as an alternative to issuing corporate debt, particularly when the contracts are of higher credit quality. We illustrate such a situation with a case study (see page 10).
• Successful investment in structured credit requires dedicated credit, trading, technology, and legal resources, institutional knowledge, and a disciplined investment process.

Introduction to ABS

Too often, we find that reports on structured credit as an asset class rely on jargon, anecdotes, inaccurate definitions, and generalizations. Our goal is to provide a coherent description that answers the following fundamental questions: Why does securitization, the process that creates structured credit investments, exist? How does structured credit differ from traditional corporate credit, mortgage lending, or leasing? What distinguishes a “securitizable” asset from other assets such as real estate, guarantees, or equity interests? How are common features of structured credit intended to help protect debt investors? What roles do originators and servicers play? What are the benefits to the borrower? Asset-backed securities are complex investments and not suitable for all investors because these instruments are subject to many risks, including credit, liquidity, interest rate, and valuation risk¹. We present this primer on securitized credit with the hope that investors can approach the sector with greater familiarity and perspective.

The Elephant in the Room

During the GFC, many investors experienced losses related to private label RMBS, CMBS, and MBS-backed CDOs. This dislocation exposed investors who based their investment decisions primarily on ratings, guarantees from monoline insurers, and a blind reliance on historical experience of the 2003–2006 credit boom to anchor future performance expectations, especially in housing and commercial real estate.

The illiquidity and credit losses investors experienced during this period led many to steer clear of the sector. In the aftermath of the GFC, however, the structured credit market underwent a painful yet necessary transformation: Market participants, including investors, issuers, arrangers, and rating agencies, returned to sustainable credit underwriting. Diverse, appropriately capitalized, cautious buyers stepped into the vacuum created by the disorderly departure of overly levered, correlated investors, thereby improving market liquidity and stability.

Despite these developments, losses and volatility always have the potential to return to certain corners of structured credit. Structured credit was not immune from downward ratings drift during the early stages of the COVID-19 pandemic, similar to what was experienced across other asset classes. However, structured credit in aggregate realized lower default rates in 2020 than corporate credit peers and their own historical averages. For example, CLOs did not experience a single default during all of 2020, and only five in 2021, according to S&P. This compares favorably to the high-yield bond market, which recorded default rates as high as 9 percent in August 2020, and the leveraged loan market, which recorded a default rate of 4.2 percent in September 2020.

Identifying which specific ABS types, structures, and securities may experience a dislocation requires dedicated credit, trading, technology, legal resources, and a disciplined investment process.

Inside ABS: Securitizable Assets and Contractual Cash Flows

Securitization begins with an agreement. One party agrees to pay another party. A family buys a home and agrees to monthly mortgage payments. A software company borrows capital to purchase a smaller competitor and agrees to the terms of a bank loan. A regional airline, looking to add routes, enters a lease agreement on an Airbus A320. A franchisee opens a drive-through restaurant and agrees to pay 5 percent of sales to Wendy’s Corp.

Look beyond the house, the software company, the airplane, and the restaurant. These agreements are all contractual obligations to pay that form the basic building blocks of securitization, or the assets backing the securitization.

You may be the proud owner of a vast vinyl record collection. Your record collection, however, doesn’t belong in a securitization. In order to serve as the collateral backing an asset-backed security, an asset must represent a contractual obligation to make payments. In other words, the assets on the left-hand side of the securitization’s balance sheet also exist as liabilities on the right-hand side of the payer’s balance sheet. Note that we refer to a “payer,” because an asset may represent the obligation to pay by a borrower, lessee, customer, or licensee, among others. Contrary to common understanding, “hard” assets do not serve as the primary collateral for securitizations. Only contracts, such as leases, mortgages, loans, and agreements that define payment obligations create the contractual cash flows necessary for securitization.

Other sources of value, such as real estate, airplanes, or a corporate guarantee, may also be available to repay ABS investors. However, these provide only secondary security. Disciplined structured credit investors rely primarily on contractual cash flows for repayment; these other sources of value represent methods of repayment only in break-glass-in-case-of-emergency situations. Experienced and capable ABS investors seek structures and collateral that avoid direct reliance on such secondary sources of value because the history of markets has shown that the cause of a disruption in a payer’s ability to honor a contractual obligation to pay will simultaneously lead to a depreciation in the value of the related hard assets (they share a “common risk factor”).

For example, when large numbers of homeowners could not honor their mortgage payment obligations, counting on steady housing prices to support debt repayment turned out to be unrealistic. Leading up to the GFC, those who conservatively evaluated borrower ability to pay their mortgages rather than focusing upon property values generally sidestepped losses (and, in some cases, gained the insight to short the ill-constructed securitizations). Meanwhile, those investors who relied on continued home price appreciation and ignored the quality of the contractual cash flows fared poorly. We believe the specific values ascribed to real estate, companies, planes, ships, and intellectual property derive from the quality of the underlying cash flows, not the other way around.

SPVs: The Structure of Structured Credit

Securitization, the act of creating asset-backed securities, begins with the creation of a special purpose vehicle, or SPV. Think of an SPV as a company with no purpose other than to acquire assets and issue debt secured by those assets. The SPV, also called the “issuer,” purchases a specific pool of assets and simultaneously issues debt securities—the asset-backed securities—and equity interests to fund the purchase of those assets. The pool of assets are typically of one type (auto loans, aircraft leases, corporate loans, etc.) but often are comprised of diverse and numerous “payers.”

Often, but not always, the SPV issues multiple classes of debt with different priority of payment, which are called tranches. Other important steps in this securitization process include the assignment of a servicer or manager, assignment of a trustee, issuance of a rating on the issued debt tranches, and the establishment of an assortment of rules to govern the securitization. These rules dictate how the trustee distributes cash flow from the asset pool between the principal and interest due on the debt tranches and equity interests, what sort of assets the SPV can own, what to do when assets pay off early, and whether cash can be used to purchase new assets. They also prescribe what happens when things go wrong, such as when the assets do not generate enough cash, or there is a precipitous decline in their quantity and/or quality. The governing documents also establish the content of the periodic investor reports, spelling out the roles, ratings and rules, and much more. Usually, the bond indenture serves as the governing document, but some securitizations may use a credit agreement, a trust deed, or a servicing agreement. Needless to say, navigating these documents efficiently and thoroughly requires significant experience, dedicated resources, and a disciplined investment process.

More than MBS: ABS Collateral Types Are Familiar and Diverse

At its inception in the mid-1980s, the non-mortgage ABS market began with securitizations of auto loans and credit card receivables. Since then, the sector has rapidly evolved into a highly diversified $1.5 trillion market, running the gamut of collateral types. Within structured credit, investors can construct a portfolio of various collateral types, providing additional diversification benefits at the investor portfolio level. Real estate-related securitized credit, including Agency and non-Agency RMBS and CMBS, technically represent types of ABS, but their investment considerations differ significantly enough that we consider them distinct asset classes. Non-real estate ABS collateral types can be grouped into two main subsectors, consumer and commercial:

• Consumer ABS are backed by cash flows from personal financial assets, such as student loans, credit card receivables, and auto loans.
• Commercial ABS are constructed from pools of receivables, loans, or leases on assets, such as shipping containers, data centers, aircraft, and other commercial equipment. Commercial ABS also include collateralized loan obligations (CLOs) backed by corporate bank debt or commercial real estate loans, and, on occasion, collateralized bond obligations (CBOs) backed by high-yield bonds.

Other non-mortgage securitized assets include merchant credit card advances, oil and gas future production royalty agreements, commission agreements, drill-ship charter agreements, property assessed clean energy loans, wireless tower leases, billboard leases, consumer wireless contracts, and wireless spectrum agreements. For a more comprehensive list of ABS types, see Appendix A.

Investor-Friendly Features of Securitized Credit

Bankruptcy Remoteness: Most securitizations involve a sponsor, typically a lender, specialty finance company, institutional investor, or corporation. If that sponsor gets into financial trouble, it can usually file for protection of its assets from creditors under the bankruptcy code, forcing all creditors into a standstill. However, in a securitization, the SPV that issues the debt is separate and distinct from the sponsor. Bankruptcy protection for the sponsor does not extend to the liabilities of the SPV. Further, the assets of SPV will not be available to the sponsor’s other creditors, providing ABS investors with a layer of protection from financial stress experienced by the sponsor.

Excess spread and triggers: As illustrated below, the expected yield or return of the underlying asset pool usually exceeds the average yield of the issued ABS debt.

In the normal course, excess spread cash flow goes to the SPV’s equity investors. However, in the event of deterioration in the quality and/or quantity of the underlying loan pool, the CLO may breach a “trigger.” A breached trigger will require that excess spread be diverted away from the equity investors to either repay principal of the CLO’s most senior tranche or to purchase additional collateral. If pool performance deteriorates further, triggers may also require that interest be diverted away from junior debt tranches to repay the senior-most tranche. As such, excess spread serves as a cushion for debt investors. It is important to note that not all types of securitizations have excess spread.

Closely tied to the concept of cash flow tranching, most securitizations provide for amortization, or return of principal, ahead of the expected maturity, which may mitigate risk of loss without any investor action or hedging. The most prominent example being in RMBS where collateral prepayments are the majority contributor to bond amortization. Compare this to corporate or municipal debt where amortization is rare and a large principal payment by the borrower at maturity (usually from refinancing proceeds) are typically required, introducing an element of term or maturity risk. As a result, securitized credit investors usually take less borrower refinancing risk than corporate or municipal debt investors or commercial mortgage lenders².

Professional Servicing and Active Management: The servicer, also referred to as the collateral manager, seeks to maximize the certainty and quantity of cash flows from the underlying pool of assets. Responsibilities of the servicer may include evaluating credit quality of payers and assets prior to inclusion in the pool, negotiating pricing and terms of loans and leases, remarketing equipment for lease, negotiating with nonperforming lessees or borrowers, obtaining appraisals, and selling hard assets. In many transactions, the servicer or an affiliate owns the equity or residual interest in the securitization, which generally creates a favorable alignment of interest with the debt investors. A major distinction exists between static pools and actively managed pools. In static pools, cash flows from the collateral may not be reinvested in new collateral. In actively managed, or reinvesting, securitizations, the manager may purchase new assets with proceeds received from existing assets, subject to strict eligibility criteria.

Investment Grade Ratings: Securitizations represent a bankruptcy remote lien on diverse, contractually cash flowing assets, and consequently rating agencies generally assign investment-grade ratings to many of the issued debt tranches. However, the repayment of debt relies on contractual cash flows and does not generally benefit from recourse to the sponsor or asset originator. As a result, securitized debt ratings rely solely on those cash flows and do not give significant credit for potential active management of the collateral or refinancing. “Rated” maturities are therefore in excess of 20 years, even though the expected maturities generally range from one to 10 years, depending on the product type.

Professional Reporting: Each securitization employs a third-party trustee that, among other responsibilities, distributes periodic performance reports to investors. These reports, generally prepared by the servicer, relay information about the underlying collateral’s composition, quality, and payment performance. While the content of the reports varies by securitization type, in each case these reports meaningfully contribute to liquidity and facilitate risk management, as they allow existing and prospective investors to evaluate the performance and outlook of the securitization.

ABS: What’s In It for the Borrower?

Securitizations provide debt capital to two types of borrowers: They may fund the loans or leases originated by lenders, lessors, or other specialty finance companies. Alternatively, securitizations may provide debt capital to traditional corporate borrowers who have contracts or own assets that are of higher financial quality than their own full faith and credit.

For all borrowers, a benefit of securitization is that the term of ABS borrowing matches the term of the underlying assets, insulating them from mark-to-market or refinancing risks. From the traditional corporate borrower’s perspective, the benefits of financing through securitization include:

• Term of financing matches tenor of assets, reduces refinancing risk, and eliminates potential for forced asset sales
• Lower borrowing costs than alternatives such as senior unsecured bonds
• Non-recourse to the sponsor, may provide off-balance sheet treatment
• Diversity of funding sources may improve enterprise valuation for sponsor

In each case, borrowers pledge loans, leases, or other securitizable assets as collateral that exceeds the same borrower’s intrinsic creditworthiness. In other words, the securitization investor tables the difficult question, “Will the borrower repay me?”—indeed, payments are not guaranteed by the corporation—and instead asks the simpler question: “Will these assets (loans, leases, etc.) generate enough contractual cash flow to repay me?”

The following case study illustrates the benefits of securitization to a traditional corporate borrower. This $2 billion securitization by Domino’s Pizza employed the basic structure, mechanics, and priority of payments for ABS. In contrast to multi-tranche ABS structures, this securitization is characterized by a single-term tranche of debt and a pari-passu (equal rank to the term tranche) revolver backed by the same assets.

Investing in ABS

Any investor considering an allocation to ABS should ask two questions in order to understand pricing of structured credit.

A prospective ABS investor must answer two questions: First, despite the previously mentioned risk-mitigating attributes of securitization, why has structured credit continued to offer additional yield when compared to similarly rated corporate, municipal, or Agency debt? Second, within structured credit, which factors help investors understand the relative pricing of different ABS?

As to the first question,the reasons for ABS’s yield premium mostly concern liquidity, information discrepancies, and historical experience:

• Most broad market indexes, including the Bloomberg U.S. Aggregate Bond Index, do not include structured credit securities. Investors thus perceive, unfairly in some cases, reduced liquidity versus competing fixed-income products.
• Structured credit securities trade over the counter, not on an exchange or electronic trading system.
• ABS reporting, while appropriate for their structure, does not resemble the quarterly disclosures of traditional corporate borrowers. This may tend to hinder crossover interest from traditional corporate debt investors.
• A shifting regulatory landscape has created uncertainty, particularly for banks’ capital charges.
• Price volatility, rating downgrades, and credit losses experienced during the financial crisis still haunt some securitized credit investors.
• Finally, the complexity of the documentation and structure of ABS and other securitized products requires a deeper investment in the necessary resources, including human capital, technology, and data.
• Note that none of these reasons are related to creditworthiness or the likelihood of return of full principal and interest. Rather, the reasons are all technical, which supports our belief that structured credit offers attractive incremental return without additional risk of loss.

For the answer to the second question, investors will need to consider a number of key variables when negotiating pricing:

• With regard to the underlying assets, investors should consider the liquidity, diversity, and transparency of the underlying asset and the availability of accurate historical performance information to inform stress scenarios.
• With regard to the ABS securities themselves, investors should factor into pricing such characteristics as rating, credit enhancement, position in capital structure and tenor, the effectiveness of portfolio limits, triggers, and covenants, and each tranche’s ability to withstand hypothetical stress scenarios.
• Equally important in evaluating pricing are such factors as the allowance for reinvestment, call protection, availability of effective hedges, the manager’s resources and track record, and the quality of periodic reporting.

Appendix A: Selected ABS Types and Related Data