Like corporate bonds, non-corporate bonds such as asset-backed securities, mortgage-backed securities, municipal bonds, sovereign bonds are also exposed to credit risk.
Asset-backed Securities and Mortgage Backed Securities
The major areas to be focused by an analyst are :
1. Credit Quality of the Underlying Asset: Asset-backed security derives its credit rating from the creditworthiness of the underlying assets. The analyst should also look into the financial solvency of the issuer so as to analyze the issuer's ability to repay the debt.
Analysis of concentration risk needs to be done by the analyst. Asset securitization is mainly built on the principle that the more the borrowers in a pool, the less would be the credit risk. If there are only a few borrowers in the pool, the diversification benefit would be lost and this would lead to a higher level of default risk. To check this, analysts should set concentration limits on the amount or percentage of receivable from any one borrower. Based on whether the issuing firm has exceeded or not exceeded the concentration limit, a higher or lower rating is given. To obtain a particular credit rating and make the transaction attractive to the investors, some type of credit enhancement procedure is usually necessary. In order to cover the possibility that the loan portfolio will not generate sufficient payment to fund payments of interest when due, some form of liquidity support is provided, usually by a credit facility from a third party lender. The credit enhancement part will take care of the risk involved in such receivables that will in turn protect the SPV against potential default in respect of the receivables acquired.
Credit Enhancements: Credit enhancement of an asset-backed security implies the existence of support for one or more of the bondholders in the structure. Credit enhancement levels vary based on the credit rating provided by each rating agency to the issuer. Hence, the level of credit enhancement is decided by the rating agency. Two types of credit enhancement structures are there- external credit enhancement and internal credit enhancement. (A detailed study about credit enhancement can be seen in the chapter on asset-backed securities)
2. Performance of the Servicer: Once the lender (also called the originator) segregates its loan portfolio into homogeneous pools, which are then transferred to a Special Purpose Vehicle (SPV), interest and principal on the underlying pool of assets are collected and transmitted to the investors by a designated party called servicer which can also be the original lender i.e., the seller. Apart from this, the servicer is also responsible for a host of things like recovering and disposing of the underlying assets in case of default by the borrower, in determining the interest rate from time to time in case of a floating-rate securities, and taking care of payments in case of delinquencies in payments. Servicer plays a very important role in asset-backed securities transactions. Therefore, an analyst should also look into the performance of the servicer before rating asset-backed securities. Some of the factors that need to be considered while rating these securities are- past history, experience, the ability of the servicer, financial condition, etc. Based on the overall ability of the seller, a rating is given by the rating agency.
3. Analysis of Structure: An asset-backed security can be based either on a pass-through payment structure or a pay through payment structure. In a pass-through structure, each certificate holder will be allotted a proportion of the cash flow from the underlying pool of loans or receivables on a pro rata basis.
In a pay-through structure, while a senior tranche can be split into different tranches, a subordinated tranche cannot be done so. The combined par value of the components of the senior tranche will be equal to the par value of the original senior tranche. A detailed study of the structure can be seen in the chapter on asset-backed securities.
An analyst is required to analyze the structure and test if the underlying assets cash flow, which mainly includes of interest and principal repayment, would match the payments like interest and principal to the investors, servicing fees and other expenses that an issuer is responsible for.
4. Legal Structure: A corporate entity may retain some interest in the underlying loans which set as the collateral for the asset-backed securities issued. In such a case the analyst should make sure that in case of bankruptcy, the investor of the security will have priority over the creditors of the corporate entity. For this purpose, the collaterals are sold to a Special Purpose Vehicle (SPV) and then the SPV resells the collateral to the trust. On behalf of the investor, the trust would be holding the assets. Through this process we see that instead of the corporate entity holding the interest in the collateral, the SPV would retain interest.