Pass Through Certificates and Pay Through Certificates
There is no uniform name for the securities issued by the special purpose vehicle (SPV) as such securities take different forms. These securities could either represent a direct claim of the investors on all that the SPV collects from the receivables transferred to it: in this case, the securities are called pass through certificates as they imply certificates of proportional beneficial interest in the assets held by the SPV. Alternatively, the SPV might be re-configuring the cash flows by reinvesting it, so as to pay to the investors on fixed dates, not matching with the dates on which the transferred receivables are collected by the SPV. In this case, the securities held by the investors are called pay through certificates.
1. Pass Through Certificates
In case of pass through certificates payments to investors depend upon the cash flow from the assets backing such certificates. In other words as and when cash (principal and interest) is received from the original borrower by the SPV it is passed on to the holders of certificates at regular intervals and the entire principal is returned with the retirement of the assets packed in the pool. The investors in a pass through transaction acquire the receivables subject to all their fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayments, etc. are transferred to the investors. Thus, pass through have a single maturity structure and the tenure of these certificates is matched with the life of the securitized assets. All investors receive proportional payments – no slower or faster repayment, though in some cases, some investors may be senior over others.
2. Pay Through Certificates
On the other hand pay through certificates has a multiple maturity structure depending upon the maturity pattern of underlying assets. Thus, two or three different types of securities with different maturity patterns like short term, medium term and long term can be issued. The greatest advantage is that they can be issued depending upon the investor’s demand for varying maturity pattern. This type of is more attractive from the investor’s point of view because the yield is often inbuilt in the price of the securities themselves i.e. they are offer at a discount to face value as in the casa of deep-discount bonds.
In case of Pay Through Certificates, the SPV instead of transferring undivided interest on the receivables issues debt securities such as bonds, repayable on fixed dates, but such debt securities in turn would be backed by the mortgages transferred by the originator to the SPV. The SPV may make temporary reinvestment of cash flows to the extent required for bridging the gap between the date of payments on the mortgages along with the income out of reinvestment to retire the bonds. Such bonds were called mortgage – backed bonds.
Preferred Stock Certificates
Preferred stocks are instruments issued by a subsidiary company against the trade debts and consumer receivables of its parent company. In other words subsidiary companies buy the trade debts and receivables of parent companies to enjoy liquidity. Thus trade debts can also be securitized through the issue of preferred stocks. Generally these stocks are backed by guarantees given by highly rated merchant banks and hence they are also attractive from the investor’s point of view. These instruments are mostly short term in nature.
Asset Backed Commercial Papers
This type of structure is mostly prevalent in mortgage backed securities. Under this the SPV purchases portfolio of mortgages from different sources (various lending institution) and they are combined into a single group on the basis of interest rate, maturity dates and underlying collaterals. They are then transferred to a Trust which in turn issued mortgage backed certificate to the investors. These certificates are issued against the combined principal value of the mortgages and they are also short term instrument. Each certificate is entitled to participate in the cash flow from underlying mortgages to his investments in the certificates.
Other Types of Securitized Instruments
Apart from the above there is also other type of certificate namely
- Interest Only Certificates
- Principal Only Certificates.
In the case of interest holding certificate payments are made to investors only from the interest incomes earned from the assets securitized. As the very name suggest payment are made to the investors only from the repayment of principal by the original borrower. In the case of principal only certificates these certificate enables speculative dealings since the speculators know well that the interest rate movements would affect the bond value immediately. For instance the principal only certificate would increase the value when interest rate go down and because of these it becomes advantageous to repay the existing debts and resort to fresh borrowing at lower cost. This early redemption of securities would benefit the investors to a greater extent. Similarly when the interest rate goes up, interest holding certificate holders stand to gain since more interest is available from the underlying assets. One cannot exactly predict the future movements of interest and hence these certificates give much scope for speculators to play the game.