Learning Module 18
ABS Instrument and Market Features

Covered bonds: Senior debt obligations issued by a financial institution and backed by a segregated pool of assets (typically commercial/residential mortgages or public sector assets).

Dual recourse: Investors have recourse to both the ringfenced cover pool and the unencumbered assets of the issuer in case of bankruptcy.

Not a true securitization: Loans remain on the issuer's balance sheet and are ringfenced into a separate cover pool (unlike ABS which transfers assets to an SPE).

Overcollateralization: Cover pool value exceeds the face value of issued bonds (e.g., Germany requires at least 2% overcollateralization).

LTV standards: Mortgages in the cover pool must meet certain loan‑to‑value criteria; non‑performing or prepaid assets are replaced.

Redemption regimes:

• • Hard‑bullet: Default triggered if payments not made on schedule; payments accelerated.

• • Soft‑bullet: Default delayed until a new final maturity date (up to 1 year after original).

• • Conditional pass‑through: Converts to pass‑through securities after original maturity if not fully paid.

Covered bonds typically carry lower credit risk and offer lower yields than otherwise similar ABS due to dual recourse and strict eligibility criteria.

Financial guarantees by banks or insurance companies

Letters of credit

Cash collateral accounts

The waterfall determines the order of payments to tranches and the order in which losses are absorbed.

Senior tranches are paid first and absorb losses last.

Subordinated tranches are paid last and absorb losses first.

Each bond class receives a risk rating based on collateral quality and seniority.

Non‑amortizing collateral: Credit card debt does not have scheduled principal repayments.

Revolving period (lockout): Principal repayments are reinvested to acquire additional receivables. Investors receive only finance charges and fees.

Amortization period: Principal repayments are not reinvested but distributed to ABS holders.

Early amortization (rapid amortization): Triggered if repayments are insufficient to replenish the pool or if defaults significantly alter the pool. Accelerates principal payments to investors.

Credit card ABS performed strongly through the Global Financial Crisis and COVID‑19 pandemic.

Securitize solar loans or leases — borrowers are typically prime homeowners with good payment records.

Environmental benefits: Finance green projects; may qualify as green bonds.

Pre‑funding period: Allows the trust to acquire additional qualifying assets after the transaction closes.

Attractive risk/reward profile: high levels of collateralization, credit enhancement, and relatively low default risk.

Defaulting on a solar loan is unlikely to reduce a consumer's overall payment obligation (they still need energy).

CDO: A generic term for securitization backed by a diversified pool of debt obligations.

CLO (Collateralized Loan Obligation): The most common CDO structure — collateral pool is made up of leveraged bank loans.

Other types: CBO (corporate/emerging market bonds), structured finance CDOs (backed by other CDOs), synthetic CDOs (credit derivatives).

Capital structure: Senior tranches (AAA, AA, A), mezzanine tranches (BBB, BB), and equity tranche.

Collateral manager: Actively manages the portfolio — buys and sells loans to generate sufficient cash flows and meet obligations.

Overcollateralization test: Principal value of collateral must exceed total principal value of notes issued. If breached, cash flows are diverted to senior tranches.

Ramp‑up period: After transaction closes, additional assets are added to the collateral pool.

Leveraged nature: Equity tranche holders use borrowed funds to generate returns above funding cost.

Key risks: Collateral manager performance, default risk on underlying loans, and the leveraged nature of the structure.

Performance tests: Include overcollateralization ratios, industry diversification, single obligor limits, and CCC‑rated debt limits.