Posts Tagged ‘Debt’

Amortized Loan: What It Is, How It Works, Loan Types, Example

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What Is an Amortized Loan?

An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan’s principal amount and the interest accrued. An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount. Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation.

Key Takeaways

  • An amortized loan is a type of loan that requires the borrower to make scheduled, periodic payments that are applied to both the principal and interest.
  • An amortized loan payment first pays off the interest expense for the period; any remaining amount is put towards reducing the principal amount.
  • As the interest portion of the payments for an amortization loan decreases, the principal portion increases.

How an Amortized Loan Works

The interest on an amortized loan is calculated based on the most recent ending balance of the loan; the interest amount owed decreases as payments are made. This is because any payment in excess of the interest amount reduces the principal, which in turn, reduces the balance on which the interest is calculated. As the interest portion of an amortized loan decreases, the principal portion of the payment increases. Therefore, interest and principal have an inverse relationship within the payments over the life of the amortized loan.

An amortized loan is the result of a series of calculations. First, the current balance of the loan is multiplied by the interest rate attributable to the current period to find the interest due for the period. (Annual interest rates may be divided by 12 to find a monthly rate.) Subtracting the interest due for the period from the total monthly payment results in the dollar amount of principal paid in the period.

The amount of principal paid in the period is applied to the outstanding balance of the loan. Therefore, the current balance of the loan, minus the amount of principal paid in the period, results in the new outstanding balance of the loan. This new outstanding balance is used to calculate the interest for the next period.

Amortized Loans vs. Balloon Loans vs. Revolving Debt (Credit Cards)

While amortized loans, balloon loans, and revolving debt–specifically credit cards–are similar, they have important distinctions that consumers should be aware of before signing up for one.

Amortized Loans

Amortized loans are generally paid off over an extended period of time, with equal amounts paid for each payment period. However, there is always the option to pay more, and thus, further reduce the principal owed.

Balloon Loans

Balloon loans typically have a relatively short term, and only a portion of the loan’s principal balance is amortized over that term. At the end of the term, the remaining balance is due as a final repayment, which is generally large (at least double the amount of previous payments).

Revolving Debt (Credit Cards) 

Credit cards are the most well-known type of revolving debt. With revolving debt, you borrow against an established credit limit. As long as you haven’t reached your credit limit, you can keep borrowing. Credit cards are different than amortized loans because they don’t have set payment amounts or a fixed loan amount.

Amortized loans apply each payment to both interest and principal, initially paying more interest than principal until eventually that ratio is reversed.

Example of an Amortization Loan Table

The calculations of an amortized loan may be displayed in an amortization table. The table lists relevant balances and dollar amounts for each period. In the example below, each period is a row in the table. The columns include the payment date, principal portion of the payment, interest portion of the payment, total interest paid to date, and ending outstanding balance. The following table excerpt is for the first year of a 30-year mortgage in the amount of $165,000 with an annual interest rate of 4.5%

Image by Sabrina Jiang © Investopedia 2020

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Asset-Backed Security (ABS): What It Is, How Different Types Work

Written by admin. Posted in A, Financial Terms Dictionary

Asset-Backed Security (ABS): What It Is, How Different Types Work

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What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Key Takeaways

  • Asset-backed securities (ABSs) are financial securities backed by income-generating assets such as credit card receivables, home equity loans, student loans, and auto loans.
  • ABSs are created when a company sells its loans or other debts to an issuer, a financial institution that then packages them into a portfolio to sell to investors.
  • Pooling assets into an ABS is a process called securitization.
  • ABSs appeal to income-oriented investors, as they pay a steady stream of interest, like bonds.
  • Mortgage-backed securities and collateralized debt obligations can be considered types of ABS.

Understanding Asset-Backed Securities (ABSs)

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can’t be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans, or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren’t available in any other investment.

Asset-Backed Security (ABS)

How an Asset-Backed Security Works

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use to make more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

Special Considerations

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

  • Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
  • Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
  • Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt. 
  • Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.
  • Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn’t qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

A mortgage-backed security (MBS) is sometimes considered a type of ABS but is more often classified as a separate variety of investment, especially in the U.S. Both operate in essentially the same way; the difference lies in the underlying assets in the portfolio. Mortgage-backed securities are formed by pooling together mortgages exclusively, while ABSs consist of any other type of loan or debt instrument (including, rather confusingly, home equity loans). MBSs actually predate ABSs.

Auto Loan ABS

Car financing is another large category of ABS. The cash flows of an auto loan ABS include monthly interest payments, principal payments, and prepayments (though the latter is rarer for an auto loan ABS is much lower when compared to a home equity loan ABS). This is another amortizing loan.

Credit Card Receivables ABS

Credit card receivables—the amount due on credit card balances—are a type of non-amortizing asset ABS: They go to a revolving line of credit, rather than towards the same set sum. So they don’t have fixed payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually a lock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the lock-up period, the principal payment is passed on to ABS investors.

Student Loan ABS

ABSs can be collateralized by either government student loans, guaranteed by the U.S. Dept. of Education, or private student loans. The former have had a better repayment record, and a lower risk of default.

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

What Is an Example of an Asset-Backed Security?

A collateralized debt obligation (CDO) is an example of an asset-based security (ABS). It is like a loan or bond, one backed by a portfolio of debt instruments—bank loans, mortgages, credit card receivables, aircraft leases, smaller bonds, and sometimes even other ABSs or CDOs. This portfolio acts as collateral for the interest generated by the CDO, which is reaped by the institutional investors who purchase it.

What Is Asset Backing?

Asset backing refers to the total value of a company’s shares, in relation to its assets. Specifically, it refers to the total value of all the assets that a company has, divided by the number of outstanding shares that the company has issued.

In terms of investments, asset backing refers to a security whose value derives from a single asset or a pool of assets; these holdings act as collateral for the security—”backing” it, in effect.

What Does ABS Stand for in Accounting?

In the business world, ABS stands for “accounting and billing system.”

What Is the Difference Between MBS and ABS?

An asset-based security (ABS) is similar to a mortgage-backed security (MBS). Both are securities that, like bonds, pay a fixed rate of interest derived from an underlying pool of income-generating assets—usually debts or loans. The main difference is that an MBS, as its name implies, consists of a package of mortgages (real estate loans). In contrast, an ABS is usually backed by other sorts of financing—student loans, auto loans, or credit card debt.

Some financial sources do use ABS as a generic term, encompassing any sort of securitized investment based on underlying asset pools—in which case, an MBS is a kind of ABS. Others consider ABSs and MBSs to be separate investment vehicles.

How Does Asset Securitization Work?

Asset securitization begins when a lender (or any company with loans) or a firm with income-producing assets earmarks a bunch of these assets and then arranges to sell the lot to an investment bank or other financial institution. This institution often pools these assets with comparable ones from other sellers, then establishes a special-purpose vehicle (SPV)—an entity set up specifically to acquire the assets, package them, and issue them as a single security.

The issuer then sells these securities to investors, usually institutional investors (hedge funds, mutual funds, pension plans, etc.). The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the portfolio of assets.

Sometimes the issuer divides the original asset portfolio into slices, called tranches. Each tranche is sold separately and bears a different degree of risk, indicated by a different credit rating.

The Bottom Line

Asset Backed Securities (ABS) are pools of loans that are packaged together into an investable security, which can in turn be bought by investors, predominantly large institutions, like hedge funds, insurance companies, and pension funds. ABS provide a method of diversification from typical bond mutual funds or individual bonds themselves. Most importantly, they are income generating assets, typically with a higher return than a normal corporate bond, all depending on the credit rating assigned to the ABS.

The underlying assets of an ABS could consist of auto loans, credit card receivables, and even more exotic investments, such as utility bills and toll roads. Such categories of ABS are referred to by different names such as CDO’s (Collateralized Debt Obligations), which are broken down into further sub-categories, such as CLO’s (Collateralized Loan Obligations). However, by far, the most popular and therefore liquid ABS are MBS (Mortgage Backed Securities), which provide an income stream from mortgage payments.

For the investor, ABS provide an income stream in line with the credit rating of the security, and offer an alternative to standard bond mutual funds.

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Asset/Liability Management: Definition, Meaning, and Strategies

Written by admin. Posted in A, Financial Terms Dictionary

Asset/Liability Management: Definition, Meaning, and Strategies

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What Is Asset/Liability Management?

Asset/liability management is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. The asset/liability management process is typically applied to bank loan portfolios and pension plans. It also involves the economic value of equity.

Understanding Asset/Liability Management

The concept of asset/liability management focuses on the timing of cash flows because company managers must plan for the payment of liabilities. The process must ensure that assets are available to pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability management process applies to different categories of assets on the balance sheet.

[Important: A company can face a mismatch between assets and liabilities because of illiquidity or changes in interest rates; asset/liability management reduces the likelihood of a mismatch.]

Factoring in Defined Benefit Pension Plans

A defined benefit pension plan provides a fixed, pre-established pension benefit for employees upon retirement, and the employer carries the risk that assets invested in the pension plan may not be sufficient to pay all benefits. Companies must forecast the dollar amount of assets available to pay benefits required by a defined benefit plan.

Assume, for example, that a group of employees must receive a total of $1.5 million in pension payments starting in 10 years. The company must estimate a rate of return on the dollars invested in the pension plan and determine how much the firm must contribute each year before the first payments begin in 10 years.

Examples of Interest Rate Risk

Asset/liability management is also used in banking. A bank must pay interest on deposits and also charge a rate of interest on loans. To manage these two variables, bankers track the net interest margin or the difference between the interest paid on deposits and interest earned on loans.

Assume, for example, that a bank earns an average rate of 6% on three-year loans and pays a 4% rate on three-year certificates of deposit. The interest rate margin the bank generates is 6% – 4% = 2%. Since banks are subject to interest rate risk, or the risk that interest rates increase, clients demand higher interest rates on their deposits to keep assets at the bank.

The Asset Coverage Ratio

An important ratio used in managing assets and liabilities is the asset coverage ratio which computes the value of assets available to pay a firm’s debts. The ratio is calculated as follows:


Asset Coverage Ratio = ( BVTA IA ) ( CL STDO ) Total Debt Outstanding where: BVTA = book value of total assets IA = intangible assets CL = current liabilities STDO = short term debt obligations \begin{aligned} &\text{Asset Coverage Ratio} = \frac{ ( \text{BVTA} – \text{IA} ) – ( \text{CL} – \text{STDO}) }{ \text{Total Debt Outstanding} } \\ &\textbf{where:} \\ &\text{BVTA} = \text{book value of total assets} \\ &\text{IA} = \text{intangible assets} \\ &\text{CL} = \text{current liabilities} \\ &\text{STDO} = \text{short term debt obligations} \\ \end{aligned}
Asset Coverage Ratio=Total Debt Outstanding(BVTAIA)(CLSTDO)where:BVTA=book value of total assetsIA=intangible assetsCL=current liabilitiesSTDO=short term debt obligations

Tangible assets, such as equipment and machinery, are stated at their book value, which is the cost of the asset less accumulated depreciation. Intangible assets, such as patents, are subtracted from the formula because these assets are more difficult to value and sell. Debts payable in less than 12 months are considered short-term debt, and those liabilities are also subtracted from the formula.

The coverage ratio computes the assets available to pay debt obligations, although the liquidation value of some assets, such as real estate, may be difficult to calculate. There is no rule of thumb as to what constitutes a good or poor ratio since calculations vary by industry.

Key Takeaways

  • Asset/liability management reduces the risk that a company may not meet its obligations in the future.
  • The success of bank loan portfolios and pension plans depend on asset/liability management processes.
  • Banks track the difference between the interest paid on deposits and interest earned on loans to ensure that they can pay interest on deposits and to determine what a rate of interest to charge on loans.

[Fast Fact: Asset/liability management is a long-term strategy to manage risks. For example, a home-owner must ensure that they have enough money to pay their mortgage each month by managing their income and expenses for the duration of the loan.]

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30-Year Treasury: Meaning, History, Examples

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What Is the 30-Year Treasury?

The 30-Year Treasury is a U.S. Treasury debt obligation that has a maturity of 30 years. The 30-year Treasury used to be the bellwether U.S. bond but now most consider the 10-year Treasury to be the benchmark.

Key Takeaways

  • 30-year Treasuries are bonds issued by the U.S. government and have a maturity of 30 years.
  • Other securities issued by the U.S. government include Treasury bills, notes, and Inflation-Protected Securities (TIPS).
  • 30-year Treasuries pay interest semiannually until they mature and at maturity pay the face value of the bond.

Understanding the 30-Year Treasury

The U.S. government borrows money from investors by issuing debt securities through its Treasury department. Debt instruments that can be purchased from the government include Treasury bills (T-bills), notes, and Treasury Inflation-Protected Securities (TIPS). T-bills are marketable securities issued for terms of less than a year, and Treasury notes are issued with maturities from two to 10 years.

TIPS are marketable securities whose principal is adjusted by changes in the Consumer Price Index (CPI). When there is inflation, the principal increases. When deflation sets in, the principal decreases. U.S. Treasury securities with longer-term maturities can be purchased as U.S. Savings bonds or Treasury bonds.

Special Considerations

Treasury bonds are long-term debt securities issued with a maturity of 20 years or 30 years from the issue date. These marketable securities pay interest semi-annually, or every six months until they mature. At maturity, the investor is paid the face value of the bond. The 30-year Treasury will generally pay a higher interest rate than shorter Treasuries to compensate for the additional risks inherent in the longer maturity. However, when compared to other bonds, Treasuries are relatively safe because they are backed by the U.S. government.

The price and interest rate of the 30-year Treasury bond is determined at an auction where it is set at either par, premium, or discount to par. If the yield to maturity (YTM) is greater than the interest rate, the price of the bond will be issued at a discount. If the YTM is equal to the interest rate, the price will be equal to par. Finally, if the YTM is less than the interest rate, the Treasury bond price will be sold at a premium to par. In a single auction, a bidder can buy up to $5 million in bonds by non-competitive bidding or up to 35% of the initial offering amount by competitive bidding. In addition, the bonds are sold in increments of $100 and the minimum purchase is $100.

30-Year Treasury vs. Savings Bonds

U.S. Savings bonds, specifically, Series EE Savings bonds, are non-marketable securities that earn interest for 30 years. Interest isn’t paid out periodically. Instead, interest accumulates, and the investor receives everything when they redeem the savings bond. The bond can be redeemed after one year, but if they are sold before five years from the purchase date, the investor will lose the last three months’ interest. For example, an investor who sells the Savings bond after 24 months will only receive interest for 21 months.

Because the U.S. is seen as a very low-risk borrower, many investors see 30-year Treasury interest rates as indicative of the state of the wider bond market. Normally, the interest rate decreases with greater demand for 30-year Treasury securities and rises with lower demand. The S&P U.S. Treasury Bond Current 30-Year Index is a one-security index comprising the most recently issued 30-year U.S. Treasury bond. It is a market value-weighted index that seeks to measure the performance of the Treasury bond market.

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