Securitization Debt Instruments - A Complete Guide For Investors

The allure of securitization began during the late seventeenth and early eighteenth centuries when the first mercantilist corporations ensued as vehicles of sovereign debt securitization for the British Empire. Soon, this was treated as an instrument by which financial institutions and corporations could identify new sources of funding. This was executed either by moving assets off balance sheets or by borrowing against them to refinance at a fair market rate. The benefits thus obtained were in terms of reduced borrowing costs, flexible transactions attuned to the risk tolerance of investors, and a greater range of investable assets to consider. For banks, securitization lowered regulatory minimum capital requirements. Today, the entire landscape of securitization has evolved, enabling investors to consider assets beyond traditional mortgages, bank loans, and or consumer loans to other asset types, such as home equity loans, lease receivables, and small business loans. Improved modelling, risk quantification, and greater data availability are some of the improvements responsible for driving such a rapid transition in the debt security market.

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Understanding Debt Securitization – Definition, Types, and Benefits

Securitization is the ultimate financial remedy for investors who can take out non-tradable assets and sell them as tradable shares. The process where assets are converted into securities is called securitization.

For example, when an issuer frames a marketable financial instrument by merging financial assets, they usually consider mortgage loans and consumer or commercial debt. Investors buying such securities will receive the principal and interest payments for the underlying assets.

Mortgage-backed bonds are the most common type of securitized debt, but any loan-backed asset can also be securitized. For example, auto loans, commercial debt, credit cards, and student loans can be pooled to create securitized debt instruments. Non-mortgage-backed securities are typically referred to as asset-backed securities (ABS), allowing banks to pursue personal assets in case of default. There are other types of securitized debt instruments available to investors in the market as well. 

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Here's a brief overview of each type, as mentioned above:

Collateralized Debt Obligation (CDO)

Collateralized debt obligation bundles loans and debt instruments into securities backed by a diversified credit asset pool. This offers collateral protection as assets can be liquidated if borrowers’ default.

Pass-through Securitization

An intermediary collects payments from a securitized loan pool, retaining a fee, and passes residual cash flows to investors. This provides targeted exposure to interest and principal repayments.

Pay-through Debt Instrument

Investors own securities backed by an asset pool. Pay-through debt instruments offer issuers flexibility to adjust payment flows and terms, using the pool as collateral rather than a direct cash flow source.

Benefits of Debt Securitization

Debt securitization has numerous benefits for investors, such as creating a diversified portfolio of assets that evenly distributes the risk and increases the rate of returns. Additionally, this instrument is advantageous for the economy as a whole. 

Here’s a brief overview of each can benefit from debt securitization:

Benefits for Investors

Here are some reasons why brokerages are aggressively confident and assertive about securitized debt instruments:

1. Diversification

Securitized debt instruments can easily diversify investment portfolios. This is a smart move to reduce risks while earning good returns from a mix of investments. Recently, inflation has risen above fixed deposit rates. While the inflation rate in 2022 was 6.67%2, it hit a 15-month high of 7.44% in July 2023, closer to its previous high of 7.79% in April 2023. Additionally, bank fixed deposits have higher yields ranging from 6.25 to 7.25%. Therefore, many traditional investments are getting negative real returns. This situation can seriously lead to wealth reduction. Also, diversifying portfolios to non-stock market-linked instruments promises higher returns. Here, securitized debt instruments group small-ticket loans from various sources into a single package, allowing investments to be diversified across different products and geographic locations. This structure enables acquiring tranches that align with varying investment objectives, which can lower risk because it is not all tied to just one investment potentially going wrong.

2. Reduced Credit Risk

The underlying asset ownership is transferred to a separate legal entity called a Special Purpose Vehicle (SPV), which protects the SDI from even the remotest chance of bankruptcy. Hence, SDI investors are shielded from minimized credit risk. Contrarily, stocks lack such robust protection mechanisms and show high volatility. Since the onslaught of the COVID-19 pandemic, Indices have been showing volatility. Therefore, as an example, if the company you have bought shares from suddenly confronts financial troubles, your investment's value could decline or become worthless. This makes SDIs safer compared to stock markets in terms of credit risks.‍

3. Accessibility For Small Investors

Securitized debt instruments are accessible to a wide range of investors and also cover instruments that might not have a hefty amount of capital, which makes brokerages bullish on them. If we look into traditional mortgage investments, they can be quite demanding. They require a significant upfront investment and often take years to see substantial returns. Moreover, many investment options regulated by the Securities and Exchange Board of India (SEBI) come with high entry barriers. This typically means you need a substantial investment amount or a considerable net worth. SDIs offer a unique opportunity for investors with limited capital to gain profits. They help transform groups of debts or assets into tradable securities, making them liquid and accessible to a broader investor base. As a result, investors can avoid paying high initial costs and wait for long gestation periods to see the returns.

4. Feasibility And Reliability

Brokerages consider securitized debt instruments reliable and practical. The structured nature of SDIs and the dependable assurance of consistent payments make brokerages bullish.

The investment market is complicated and ridden with challenges like high inflation and volatility. This nature challenges investors to maintain steady returns, which can erode their purchasing power over time. 

Yet, SDI investors get regular monthly payments. These payments include both interest and principal amounts. Initially, these payments are primarily made up of interest. But gradually, a mix of interest and more of your principal is coming back to you. It is a structured approach, aiming to provide you with a consistent income stream over time.

5. Enhanced Credit Ratings

When choosing where to invest, brokerages and individuals are inclined towards assets with good credit ratings. The reason being, such assets offer investors a sense of security and stability. Securitized debt stands out for its elevated creditworthiness, giving brokerages a positive outlook. They are treated separately from their parent entities. The separation allows them to boast excellent credit ratings often. An SDI with a strong credit rating indicates a lower risk level. As a result, potential investors are more likely to consider it a viable investment option. This way, they try to minimize risk while aiming for consistent and higher returns.

Furthermore, their positive outlook can lead to optimism among more investors. The resultant risk-free perception of SDIs can eventually increase their demand. This can drive up their prices and make them favourable investments in the eyes of brokerages and investors alike. Note that no investment is 100% free of risks. Despite being backed by tangible assets, SDIs carry risks. Defaults can happen, and that can affect the returns. And then, there is a scenario where homeowners decide to refinance their loans. This might lead to earlier-than-expected payouts to investors, ultimately affecting the returns.

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Benefits for the Economy

Expanded Credit Access: By freeing up lender capital, securitization makes credit more accessible for consumers and businesses, driving economic growth.

Distributed Risk: Securitization distributes risk across a vast pool of investors. This helps reduce the strain on individual lenders and fosters financial stability during downturns.

Broader Investment attracts diverse investors, channels funds into various sectors, and encourages economic development across multiple industries.

Evaluating The Debt Securitization Process

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Understanding the nuts and bolts of debt securitization can truly help investors in their wealth accumulation journey. To begin the journey, let’s get a sneak peek into the process that covers several steps:‍

Step 1: Originator

A non-banking financial company (NBFC), also known as the Originator, underwrites and classifies loans, receivables, or leases into specific groups based on factors like maturity, credit risk, or interest rate sensitivity to provide to a pool of borrowers.

Step 2: Special Purpose Vehicle (SPV)

Next, the assets are transferred to a Special Purpose Vehicle (SPV), which acts as an independent entity. The SPV, often structured as a SEBI-registered trust, can be established by banks, financial institutions, or the Originator itself. It legally securitizes the assets from the Originator, ensuring that the risks associated with these assets are isolated.

Step 3: Dividing Securities

Once the assets are in the SPV, they are divided into various asset-backed securities and issued to investors by the Trust. These securities are generated against an upfront consideration. 

Step 4: Disbursement of Funds

Principal and interest collected against loans are also referred to as receivables. The Trust collects them and distributes them to investors based on the terms of the securities they hold.

Cons of Investing in Securitized Debt

Investing in securitized debt offers unique opportunities for portfolio diversification and higher returns, but it also comes with certain risks. Understanding the cons is crucial for making informed investment decisions in these complex financial instruments.

Complexity

 Debt securitization is a complex process, and the resulting securities can be challenging to understand, especially for retail investors. These instruments often involve multiple layers of debt, varying risk profiles, and sophisticated financial structures, making it difficult for investors to grasp the associated risks fully.

Risk of Default

Although securitized debt offers the opportunity to diversify risk, it still needs to be eliminated. If the underlying borrowers default on their loans, investors may face significant losses. For example, during the 2008 financial crisis, many investors in mortgage-backed securities experienced large-scale defaults, leading to massive losses.

Interest Rate Sensitivity

Securitized debt instruments are sensitive to changes in interest rates. When interest rates rise, the value of these securities may decline. Rising interest rates can negatively impact the market value of long-term securitized debt instruments.

Illiquidity in Times of Crisis

While securitized debt is generally more liquid than individual loans, it can become illiquid during financial stress. During a market downturn, finding buyers for certain types of securitized instruments and significantly riskier tranches can be difficult.

Lack of Transparency

The underlying assets in a securitized pool are only sometimes transparent to investors, making it difficult to assess the quality of the debt. Some securitized debt instruments may contain high-risk loans that are not readily apparent, increasing the risk for investors.

Securitized Debt Instruments in India - A Growing Opportunity

In the first quarter of the financial year 2023-24, the securitization market reached new heights, with a 60% surge in volume compared to the previous year, amounting to INR 55,000 crore. This unprecedented growth reflects strong investor interest and highlights the expanding role of SDIs in the investment landscape. Despite challenges during the pandemic, India’s securitization market has rebounded swiftly, with the total volume of securitized  assets in FY 2022-23 expected to reach around INR 1.9 lakh crore, nearing pre-pandemic levels. SDIs in India are often backed by robust asset classes, such as housing loans, auto loans, and other credit receivables, giving investors a steady income stream from principal and interest payments. However, as with any evolving market, it is essential to conduct thorough due diligence before investing in securitized debt instruments.

For investors seeking diversification, steady returns, and exposure to new asset classes, SDIs present an attractive opportunity to participate in India’s flourishing financial market while mitigating risks through a structured, asset-backed approach.

At Cube Wealth, we recognize the growing potential of SDIs (Securitization Debt Instruments) as a way to diversify portfolios while benefiting from relatively lower-risk, asset-backed securities. We connect you with our experienced wealth managers, who will advise you on various nitty-gritty aspects of wealth management and impart knowledge on different investment instruments like debt securitization, ensuring you get the proper guidance for your financial future.

Understanding Krazybee from a Close-Up Lense

KrazyBee Services Private Limited, a Non-Banking Financial Institution (NBFC) registered with the Reserve Bank of India, offers a unique lending solution aimed at addressing India's key financial challenges. Leveraging innovative, next-gen technology, KrazyBee provides accessible credit options, crafted by a team of seasoned entrepreneurs and finance experts to transform the lending landscape.

Key Investment Highlights of Krazybee Work

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Diversified Loan Pools

A carefully selected mix of thousands of Personal, Microfinance, and MSME loans, all originated by an investment-grade NBFC.

Risk-adjusted Returns

Targeting a pre-tax net IRR of 11.8% can offer 100-250 bps higher returns compared to similarly rated corporate bonds, with monthly interest payouts.

Secured and Remote Bankruptcy

A strong security package covers 30-60% of the investment, ensuring minimal risk even if 20% of the portfolio defaults, independent of the originator's bankruptcy.

RBI/SEBI Regulations

Structured in compliance with RBI and SEBI guidelines, with SDIs held in a DEMAT account, much like bonds.

Transparent Transactions

Investors are taxed only on earned interest, with corporate interest payments added to business income, ensuring tax clarity.

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‍Building Blocks of Krazybee Security

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Loan Pool Cash Flows – Internal

Over-Collateralization (OC)

Loan pools are purchased below their principal balance, ensuring over-collateralization and added security.

Excess Interest Spread (EIS)

The leftover interest after paying investors, representing the gap between NBFC lending and borrowing rates.

Equity Tranche Investment

In select cases, the originator invests in a junior tranche, providing an extra layer of protection for investors.

Loan Pool Cash Flows – External

Cash Collateral (CC)

A bank guarantee backed by fixed deposits, providing upfront liquidity for the transaction.

First/Second Loss Guarantee

Offered by the originator or third parties to enhance the transaction's creditworthiness.

Conclusion

Investing in securitized debt can provide attractive benefits such as portfolio diversification, higher yields, and stable cash flows. However, it is essential to weigh these advantages against the potential risks, including complexity, default risk, and interest rate sensitivity. By understanding the intricacies of debt securitization and carefully selecting the right tranche, investors can make more informed decisions about incorporating securitized debt instruments into their portfolios.

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