What are Pass Through Certificates (PTCs)?
They are high quality debt instruments that represent ownership in a pool of assets and derive monthly principal and interest payments from those assets. PTCs are nothing but securitization (part of structured finance), which has evolved over the past few decades, across the globe. Securitization in India largely adopts a trust structure and the underlying assets are transferred through a sale to the trustee company (special purpose vehicle/SPV).The SPV issues PTCs and investors in PTCs are entitled to a beneficial interest in the underlying assets held by the trustee.
What is Securitization?
Simply put, securitization transforms illiquid assets into liquid assets, thereby expanding the investment universe and typically has the following characteristics –
• Pooling of assets such as receivables from auto/student/equipment/house loans, credit cards, trade,leases..etc . An asset-backed security (ABS) can be created on the basis of many forms of receivables -music royalties, movie revenues,mutual fund fees, and tobacco settlement fees…etc. Housing loan backed securities are known as Residential Mortgage Backed Securities (RMBS).
• The monthly payments from the underlying assets would consist of principal and interest. Cash flows can be directly given to the investors as per pre-determined rules (pass-through structured security).
• Insulating the investors from the credit risk of the originating financial institution, through the creation of a special purpose vehicle. In other words, possibility of a higher credit rating than the originator.
• Because rating is based on the cash flows (principal/monthly interest) and not on the originators’ credit worthiness, one can cherry-pick and create a higher quality asset pool.
What is the size of securitization market and the key trends in India ?
Securitization is estimated to account for around 43% of the global debt issuance ($6.63 trillion) in the year 2007. US accounts for over 74% of the global securitization transactions, Europe contributing 23% while the rest is contributed by Australia and Asia. In India, the structured finance market consists mainly of retail asset securitization (mainly ABS) along with securitization of single corporate loans (CDOs) – ABS accounted for 53% of market volumes in 2007 and the latter accounted for 43%.The Indian securitization market size was at around Rs.550billion in 2007(Rs.215 billion in 2006).
What are the advantages to the originator?
The key advantages are –
• Monetization: Helps in monetizing intangible and illiquid assets into cash.
• Financial health: Depending on the accounting practices and the structure, securitisation can help
improve the debt-equity ratio of the firm.
• Asset-Liability Management: Given the flexibility in structuring and timing cash flows to each tranche, one can match the tenure of the liabilities and assets.
What are the risks inherent in PTCs ?
The key risks are –
• Interest Rate Risk : Like all fixed income securities, the prices of fixed rate PTCs move in response to changes in interest rates. Also interest rate changes may affect the prepayment rates, impacting yields.
• Default Risk : Default risk is the borrowers’ inability to meet interest payment obligations on time and the credit rating reflects a particular security’s default risk. However, given that we invest mostly in investment grade, this is minimized.
How do the ratings of these securities differ ?
CRISIL uses "SO" to indicate a structured obligation [AAA (SO)] and defines investment grade as AAA
(SO) to BBB (SO).Ratings of these PTCs are mainly based on credit enhancement/structured payment mechanisms, which enable a higher rating than the issuer’s stand-alone rating.The credit enhancements could be in different forms –
• Cash Collateral : Cash deposited by the originator in an account operated by the Trustee and any
short fall in collections can be met by drawing from this account.
• Corporate Undertaking : Similar to CC and short falls are met by invoking the undertaking.This
reduces cost of carry to originator.
• Apart from these two, we also have over collateral (subordinate) and excess interest spread
Do the investment and risk management process differ in the case of securitized
debt ?
The overall investment philosophy remains the same i.e., to minimize both liquidity and credit risk.We look to arrive at a general maturity/duration range for a fund’s portfolio in line with its objective and based on our interest rate outlook.The shifts within this range are then determined by short-term cyclical trends in the economy.The team looks to manage interest rate risk across different asset class and duration buckets, in order to optimize risk-adjusted returns. All the investment options are thoroughly analyzed to ensure that credit risk is kept at the minimum level. In case of securitized debt,we adopt the same rigorous investment processes and look to diversify the PTC exposure for ABS across different asset classes.We look at factors such as – historical performances of similar pools and credit collateral utilization. Pool performance indicators include ageing profiles, collection efficiency ratios and delinquency levels.
What is the nature of FT’s exposure to securitized debt at this stage?
Majority of our securitized debt exposure is currently towards single loan PTCs and the PTC exposure in ABS is towards auto pools. In the case of single loan PTCs, our investment universe is same as that considered for our corporate bond investments and in that sense, our investments are only in those companies that have been vetted using our investment process. In the case of short term funds,we have adopted a step up maturity strategy to ensure that liquidity requirements can be met in all types of market conditions.
What is the impact of the changes in macro economic conditions and rising interest
rates on PTCs (ABS)?
Typically in a rising interest rate scenario, the delinquency rates are bound to increase and we have seen this impact pools of recent vintage. Rating agencies factor this in their rating process by proactively seeking credit enhancements and ensuring adequate coverage levels.The below table clearly indicates that majority
of the pools have witnessed credit collateral utilization of less than 30%.
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