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Home > Asset Management Best Practice > Investing in Structured Finance Products in the Debt Money Markets

Asset Management Best Practice

Investing in Structured Finance Products in the Debt Money Markets

by Moorad Choudhry

Executive Summary

  • A number of structured finance investment products are available in money markets that offer investment options for cash-rich investors.

  • Products include asset-backed commercial paper, total return swaps, and collateralized committed repo liquidity lines.

  • The returns available for cash-rich investors differ according to asset credit quality, with higher yields on lower-rated assets.

  • Returns also differ by product type.

  • Investors should assess the liquidity of an instrument type as well as its credit risk.

Introduction

The application of synthetic securitization and structured finance techniques in debt capital markets has made a range of asset classes available to investors who would not otherwise have access to them. Thus banks, fund managers, and cash-rich corporate institutions can choose from a wide variety of investment options for their funds. This article introduces a sample of money market products that present alternatives for the investment of surplus funds. In each case we consider the basic product structure, and we look at the different yields across products.

The global credit and liquidity crunch in 2007–08 resulted in a widespread “flight-to-quality” as investors became excessively risk-averse. Yield spreads widened considerably and certain asset classes and products were no longer viable. We review here only instruments that remain practical products for both investors and borrowers. The products considered are:

Asset-Backed Commercial Paper

The application of securitization technology in the money markets has led to the growth of short-term instruments backed by the cash flows from other assets, known as “asset-backed commercial paper” (ABCP). Securitization is the practice of using the cash flows from a specified asset, such as residential mortgages, car loans, or commercial bank loans as backing for an issue of bonds. In the case of ABCP the assets are funded in the commercial paper market. The assets themselves are transferred from the original owner (the “originator”) to a specially created legal entity known as a “special purpose vehicle” (SPV), so as to make them separate and bankruptcy-remote from the originator. In the meantime, the originator is able to benefit from capital market financing charged at a lower rate of interest than that earned by the originator on its assets.

Figure 1 illustrates a generic securitization transaction for the debt capital markets, issuing asset-backed securities (ABS). The originator has set up the SPV, which then buys the assets from it. The SPV funds itself in the debt capital markets by issuing ABS.

Generally securitization is used as a funding instrument by companies for three main reasons: It offers lower-cost funding than traditional bank loan or bond financing; it is a mechanism by which assets such as corporate loans or mortgages can be removed from the balance sheet, thus transferring the default risk associated with those assets to investors; and it increases a borrower’s funding options. For investors it offers a class of assets that would not otherwise be available to them directly, thus widening their return options and potentially diversifying the sources of risk in their portfolio. Equally, issuing ABCP enables an originator to benefit from money market financing that it might otherwise not have access to, perhaps because its credit rating is not sufficiently strong.

When entering into securitization, an entity may issue term securities against assets into the public or private market, or it may issue commercial paper via a special purpose legal entity known as a “conduit.” These conduits are usually sponsored by commercial banks. ABCP trades as a money market discount instrument. Investors purchase it from a number of ABCP dealers who work on behalf of the conduit. The return available on ABCP is a function of the credit rating of the issuer, which is dependent on the credit quality of the underlying assets. Conduits often pay a fee to be backed by a line of credit, known as a “liquidity line,” which is supplied by a bank. The credit quality and standing of the liquidity bank also drive the credit rating of the conduit.

The assets that can be funded via a conduit program are many and varied; to date they have included:

  • trade receivables and equipment lease receivables;

  • credit card receivables;

  • auto loans and leases;

  • corporate loans, franchise loans, and mortgage loans;

  • real-estate leases;

  • investment grade-rated structured finance bonds, such as asset-backed securities (ABS).

Figure 2 illustrates a typical conduit structure for ABCP issued to the US and European commercial paper markets. (The difference in yields available on ABCP rated A1/P1 compared to bank-issued commercial paper of the same rating is illustrated in Table 2. The higher yield on ABCP reflects investor perception of the higher associated credit risk.)

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Further reading

Books:

  • Bhattacharya, Anand K., and Frank J. Fabozzi (eds). Asset-backed Securities. New Hope, PA: Frank J. Fabozzi Associates, 1996.
  • Choudhry, Moorad. Structured Credit Products: Credit Derivatives & Synthetic Securitisation. Singapore: Wiley, 2004.
  • Choudhry, Moorad. Fixed Income Markets: Instruments, Applications, Mathematics. Singapore: Wiley, 2005.
  • Choudhry, Moorad. Bank Asset and Liability Management: Strategy, Trading, Analysis. Singapore: Wiley, 2007.
  • Fabozzi, Frank J., and Steven V. Mann (eds). Securities Finance: Securities Lending and Repurchase Agreements. Hoboken, NJ: Wiley, 2005.
  • Fabozzi, Frank J., Steven V. Mann, and Moorad Choudhry. The Global Money Markets. Hoboken, NJ: Wiley, 2002.
  • Martellini, Lionel, Philippe Priaulet, and Stéphane Priaulet. Fixed-income Securities: Valuation, Risk Management and Portfolio Strategies. Chichester, UK: Wiley, 2003.

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