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Does your debt portfolio need pass-through certificates?

Investors fund PTCs and receive cash flows generated by the underlying loan pool. (iStockphoto)
Investors fund PTCs and receive cash flows generated by the underlying loan pool. (iStockphoto)

Summary

Securitization helps reduce default risk on loans by repackaging them into securities. They are complex instruments meant for sophisticated investors.

Here is how securitization helps reduce the risk of default on loans taken by a borrower. Such loans are repackaged into interest-bearing securities and sold to investors, thus spreading the risk thin. That is also what a pass-through certificate, or PTC, does. They are a type of securitization where the investors are paid interest but the final principal depends on the repayment by the borrower. It is considered risky because investors may not get the principal in full if the borrower defaults.

Historically, these PTCs have only been held by institutions like banks or mutual funds. However, some startups have now started offering them to individual investors. Wealth tech startup GripInvest, for instance, has sold PTCs and securitized debt instruments (SDIs) worth 175 crore to retail investors on its platform in the last 12 months.

The securitization market in India has experienced robust growth in the past few years. For instance, the annual aggregate for fiscal 2023 surpassed 1.8 trillion, very near the previous high of 1.9 trillion in fiscal 2019. This trend highlights PTCs’ growing popularity and their position as a reliable investment choice for debt investors in India.

Graphic: Mint
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Graphic: Mint

Listed PTCs are governed by regulations framed by market regulator Securities and Exchanges Board of India (Sebi) in 2008 on the issue and listing of SDIs and security receipts. Additionally, pursuant to representations made by the industry, in June, Sebi has expanded the categories of instruments which can be distributed by online bond platform providers (OBPPs) to retail investors, and these now include SDIs, said Nikhil Aggarwal, founder & CEO, Grip.

The securitization structure

The originators—often banks, non-banking financial companies (NBFCs), and factoring NBFCs—are responsible for raising capital against loans and receivables, forming the initial asset pool for PTCs. The servicers play a critical role in managing the loan portfolio, ensuring efficient collections. Importantly, they can be changed in cases where the originator faces financial challenges, safeguarding investor cash flows.

A special purpose vehicle (SPV), structured as a bankruptcy remote trust, holds the receivables and issues PTCs. Its primary role is to insulate securitized assets from the originator’s financial health, enhancing investor protection. An independent trustee, appointed by the originator, oversees SPV operations, ensuring compliance with regulations and safeguarding PTC holder interests.

Investors fund PTCs and receive cash flows generated by the underlying loan pool. They encompass various participants, including banks, mutual funds, institutional investors and retail investors, seeking investment opportunities in securitized assets.

All PTCs offered by Grip are credit-rated. The coupon rate attached to such instruments is typically a function of the credit rating issued for the PTC, and is decided in reference to the coupon rates for similarly rated instruments (for example, a similarly rated PTC or NCD) and the prevailing interest rate cycle, added Aggarwal.

Risk Mitigants

PTCs incorporate several inherent risk mitigation mechanisms. One key safeguard is the ‘skin in the game’ requirement, stipulated by the Reserve Bank of India (RBI), which compels the originator to invest a portion of its own capital, typically ranging from 5% to 10%, into the PTC. This contribution, known as the minimum retention requirement (MRR), aligns the originator’s interests with those of investors, reinforcing their commitment to the quality and performance of the underlying assets.

“For invoice factoring/discounting transactions, we have a concept of minimum replenishment period. Since invoices are of short duration, no principal is returned to investors during this period and money is redeployed . After the period ends, the proceeds are used to pay back interest and principal to the senior tranche (investors) and then to the equity tranche (originator)," said Shantanu Bairagi, co-founder of Artfine Group

Another risk-mitigating feature is ‘over-collateralization’, a structural characteristic that ensures for every 100 invested, 110 worth of loans is securitized. This intentional over-collateralization acts as a protective cushion, offering investors added security in the event of defaults or losses within the loan portfolio.

PTCs also employ ‘cash collateral’ mechanisms, including bank guarantees or fixed deposit liens marked in favour of the SPV by the originator. These collateral provisions serve as financial guarantees, ensuring that sufficient funds are available to cover any potential shortfalls in PTC payments.

Besides this, ‘principal subordination’ plays a critical role in risk management. In this setup, the equity tranche (originator) doesn’t get back the principal until the senior tranche (investors) has been fully paid. This subordination structure prioritizes the protection of investors’ principal, reassuring them of a higher degree of security.

In addition, another element that makes PTCs an attractive option for retail investors is the potential for ‘excess interest rate spread’ (EIS). This represents the difference between the interest earned on the underlying loans and the interest paid on the PTC. For instance, the loans may carry a weighted average interest rate of 12% while the PTC carries a 10% rate. The difference of 2% acts as a buffer in case of defaults. In certain cases, particularly where it concerns microfinance institutions, EIS can be substantial, reaching as high as 12-15%. In case there is no default, the EIS is earned by the equity or junior tranche as a reward for taking on the default risk.

Risks still exist

One primary concern is the default or credit risk at the borrower level. Regardless of the stringent selection criteria applied to borrowers, there remains the inherent risk of individual borrowers defaulting on their obligations. Such defaults can erode the efficiency of collections, potentially leading to losses within the underlying loan portfolio.

Additionally, any bankruptcy of originator/servicer introduces a unique challenge. Although PTCs are issued by the SPV that is designed to be insulated from the financial health of the originator or servicer, there are situations where the broader financial context can indirectly impact the investment. Notably, the recent case of Dewan Housing Finance Ltd (DHFL) illustrates how the seizure of fixed deposits pledged as cash collateral can result in rating downgrades for PTCs, underscoring the importance of understanding such potential vulnerabilities. DHFL faced a financial crisis due to alleged financial mismanagement and defaults, leading to severe liquidity issues and a credit rating downgrade. It resulted in a significant impact on the Indian financial sector.

Then, there is the ‘liquidity and price risk’ associated with PTCs in the secondary market. This risk stems from the market’s limited liquidity, making it challenging to determine fair market prices for mark-to-market (MTM) calculations.

The cash flows are unpredictable if the underlying pool is retail loans because of possible prepayments and overdues. So, on payout dates, investors may receive higher or lower than the expected cash flows. This variation usually does not happen where the underlying is a wholesale pool of loans, said Ajinkya Kulkarni, co-founder and CEO, Wint Wealth

In the case of factoring NBFCs, there is an additional layer of risk associated with ‘operational creditors’. Receivables classified as operational debt can pose challenges in case of invoice defaults as they may be considered subordinate to other creditors.

Bonds Vs PTCs Vs P2P

Retail pool SDIs/PTCs have some advantages over P2P, or peer to peer, lending. P2P platforms are online platforms that connect individuals directly with each other to facilitate transactions, without the need for a third-party intermediary. In the case of SDIs, the investors are aware of the underlying pool, which is reviewed and rated by a rating agency. It also has an in-built provision for loss absorption so that 15-20% of losses can be absorbed through credit enhancement. It also has easier access and liquidity since the units are held in investors’ demat accounts and listed on the exchanges, added Kulkarni.

Diversification: Bonds represent single instruments with limited diversification. PTCs pool thousands of loans for extensive diversification, reducing individual loan risk. P2P platforms, offer some diversification, but it’s more limited than PTCs.

Risk Mitigants: Bonds vary in risk; secured bonds offer collateral, unsecured ones carry more risk. PTCs employ risk mitigation mechanisms like EIS, cash collateral, and over-collateralization. In contrast, P2P platforms have only EIS.

Rating: Bonds reflect the creditworthiness of an issuer. PTCs are rated higher than originators due to structural protections. The P2P industry has only one rated player—Liquiloans,

Returns: Bonds yield returns of 9-14% and are influenced by market conditions. PTCs offer 10-13% returns based on underlying loans. P2P lending returns range from 9-12%, determined by borrower rates and platform fees.

Who is this for?

PTCs for individual investors are still in the nascent stage. They are complex instruments that are only really meant for sophisticated investors. Since the interest payments are taxed at slab rate, they carry no special tax advantages. Also, do note that the mortgage backed securities that cause the 2008 financial crisis were similar to PTCs, though at a very broad level. Make sure you know what you are getting into.

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