Securitized bonds

In addition to the more traditional cash flows from mortgages and loan assets, investment banks underwrite bonds secured with flows received by leisure and recreational facilities, such as health clubs, and other entities, such as nursing homes. Bonds securitizing mortgages are usually treated as a separate class, termed mortgage-backed securities, or MBSs. Those with other underlying assets are known as asset-backed securities, or ABSs. The type of asset class backing a securitized bond issue determines the method used to analyze and value it. 

A first kind of these insurance products are called "catastrophe bonds" and consist in securitizing environmental risks in bonds, which could be sold to high-yield investors. The catastrophe bonds are able to transfer risk to investors that receive coupons that are normally a reference rate plus an appropriate risk premium. By these products, insurance companies limit risk exposure transferring natural catastrophe risk into the capital markets. In this way, with the involvement of the financial markets, their global size offers enormous potential for insurers to diversify risks. 

Sources of finance for company acquisitions as mentioned above can be from reserves or maybe taken a senior or subordinated debt. Alternatively a bond may be issued with various characteristics offering an annuity, a balloon payment or a combination of the two. A variety of convertible structures have been utilized for this purpose as asset sales and the use of the target s balance sheet. There has also been a place for royalty transactions where the future-value of product cash flows are securitized to provide capital in the near term to achieve a company acquisition. 

As noted, a bond may contain an embedded option which permits the issuer to call or retire all or part of the issue before the maturity date. The bondholder, in effect, is the writer of the call option. From the bondholder s perspective, there are three disadvantages of the embedded call option. First, relative to bond that is option-free, the call option introduces uncertainty into the cash flow pattern. Second, since the issuer is more likely to call the bond when interest rates have fallen, if the bond is called, then the bondholder must reinvest the proceeds received at the lower interest rates. Third, a callable bond s upside potential is reduced because the bond price will not rise above the price at which the issuer can call the bond. Collectively, these three disadvantages are referred to as call risk. MBS and ABS that are securitized by loans where the borrower has the option to prepay are exposed to similar risks. This is called prepayment risk, which is discussed in Chapter 11. 

Hybrid securities. Bonds that are made up of a combination of one or more securities, or which link their performance to the performance of another bond or asset, or an index Structured notes. Bonds that combine a bond with a derivative such as an interest rate swap, or bonds that are created from securitization transactions (see chapter 14)... 

The flexibility of securitization is a key advantage for both issuers and investors. Financial-engineering techniques employed by investment banks today enable bonds to be created from any type of cash flow. The most typical such flows are those generated by high-volume loans such as residential mortgages and car and credit card loans, which are recorded as assets on bank or financial-house balance sheets. In a securitization, the loan assets are packaged together, and their interest payments are used to service the new bond issue. 

A key benefit of securitization notes is the ability to tailor risk—return profiles. For example, if there is a lack of assets of any specific credit rating, these can be created via securitization. Securitized notes frequently offer better risk—reward performance than corporate bonds of the same rating and maturity. While this might seem peculiar (why should one AA-rated bond perform better in terms of credit performance than another just because it is asset-backed ), this often occurs because the originator holds the first-loss piece in the structure. 

As illustrated in Figure 15.1, in a securitization the issued notes are structured to reflect specified risk areas of the asset pool, and thus are rated differently. The senior tranche is usually rated AAA. The lower-rated notes usually have an element of overcollateralization and are thus capable of absorbing losses. The most junior note is the lowest rated or nonrated. It is often referred to as th.t first-loss piece, because it is impacted by losses in the underlying asset pool first. The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by the originator. 

Part Two, Cash and Derivative Instruments and Analysis, has an analysis of various instruments including callable bonds that feature embedded options. There is a discussion of securitization and the impact on the market of the financial crisis. Other chapters cover U.S. Treasury TIPS securities, and the use and applications of credit derivatives. 

CAT bonds have probably been the most successful instrument used to package catastrophe risks into a securitization. This solution consists of creating a special purpose vehicle, which acts as a reinsurer to a single entity and which holds the bond principal invested in safe, low-risk, short-term securities. Cummins (2008) presents a comprehensive view of the history and types of securitizations and derivatives that have been used in the market. 

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