3.1.3.2. Types of Collateral Backing

There is a wide range of bonds that are secured by some form of collateral. Some companies issue collateral trust bonds and equipment trust certificates. Collateral trust bonds are secured by securities such as common shares, other bonds, or other financial assets. These securities are pledged by the issuer and typically held by the trustee. Equipment trust certificates are bonds secured by specific types of equipment or physical assets, such as aircraft, railroad cars, shipping containers, or oil rigs. They are most commonly issued to take advantage of the tax benefits of leasing. For example, suppose an airline finances the purchase of new aircraft with equipment trust certificates. The legal title to the aircraft is held by the trustee, which issues equipment trust certificates to investors in the amount of the aircraft purchase price. The trustee leases the aircraft to the airline and collects lease payments from the airline to pay the interest on the certificates. When the certificates mature, the trustee sells the aircraft to the airline, uses the proceeds to retire the principal, and cancels the lease.

One of the most common forms of collateral for ABS is mortgaged property. MBS are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity.

Financial institutions, particularly in Europe, issue covered bonds. A covered bond is a debt obligation backed by a segregated pool of assets called a “cover pool”. Covered bonds are similar to ABS but offer bondholders additional protection if the financial institution defaults. A financial institution that sponsors ABS transfers the assets backing the bonds to a special legal entity. If the financial institution defaults, investors who hold bonds in the financial institution have no recourse against the special legal entity and its pool of assets because the special legal entity is a bankruptcy-remote vehicle; the only recourse they have is against the financial institution itself. In contrast, in the case of covered bonds, the pool of assets remains on the financial institution’s balance sheet. In the event of default, bondholders have recourse against both the financial institution and the cover pool. Thus, the cover pool serves as collateral. If the assets that are included in the cover pool become non-performing (i.e., the assets are not generating the promised cash flows), the issuer must replace them with performing assets. Therefore, covered bonds usually carry lower credit risks and offer lower yields than otherwise similar ABS.