Pros and Cons of Asset-Backed Commercial Papers

In the previous article, we have studied how asset-backed commercial papers are different from regular commercial papers. We also know the procedure which is used to issue this variety of commercial paper. However, as an investor, we also need to understand the pros and cons related to asset-backed commercial papers.

In this article, we will have a detailed look at the pros and cons related to asset-backed commercial papers.

Advantages of Asset-Backed Commercial Papers

The main advantage of issuing asset-backed commercial papers has been listed below:

1. Off-Balance Sheet: The sponsor of the asset-backed commercial papers generally creates a special purpose vehicle entity in which they hold they hold the assets which are being used as collateral.

   Since this special purpose vehicle is completely isolated from the sponsor, there is no link between the balance sheets. Hence, for the sponsor, the issuance of asset-backed commercial papers is an off-balance sheet activity that helps them earn fees and commissions without showing additional leverage on their balance sheet.

2. Higher Yield: The asset-backed commercial papers market tends to give a higher yield as compared to similar assets in the same category. The yield is almost equivalent to regular commercial paper which is a completely unsecured debt. Since asset-backed commercial papers are secured, the risk-adjusted yield can be considered to be higher.

3. Diversification: Asset-backed commercial papers are one of the best ways for investors to achieve diversification while investing in money markets. This is because, when they generally invest in money markets, they have to choose commercial papers belonging to certain companies or they can buy treasury bills.

   All of these assets limit the exposure of the investor to a single issuer. However, asset-backed commercial papers can bundle the securities issued by several issuers. Hence, by buying single security, the investor can actually own a portfolio of well-diversified assets.

   Since more diversification means lower risk, asset-backed commercial papers are widely used by investors who want to use diversification to lower risks.

4. Credit Enhancement: Asset-backed commercial papers have a unique structure in which the special purpose vehicle is completely different from the sponsor. However, the sponsor may directly or indirectly provide various forms of credit enhancement to the asset pool. This is done in order to make the asset pool more secure and marketable.

   Credit enhancements such as credit guarantees are commonly included in the asset-backed commercial paper contract which is what makes these securities a preferred choice amongst investors.

Disadvantages of Asset-Backed Commercial Papers

The asset-backed commercial paper market also has several disadvantages. Some of these disadvantages have been explained below:

1. Liquidity Risk: Firstly, it is important to note that not all assets which for a part of the collateral pool have a similar maturity. Hence, the structure is inherently unstable. The assets have very different maturity and cash inflow patterns as compared to the cash outflow pattern. Therefore, there is always a liquidity risk that the asset pool might run out of money when it comes to making the outflow payments.

   In most cases, the sponsor provides a liquidity guarantee. However, in case the financial position of the sponsor is not good, then the liquidity risk might get magnified creating several issues for investors.

2. Valuation Risk: It needs to be understood that the value of the asset-backed commercial paper is derived from the securities which are backing these asset pools. Hence, there is an inherent risk that the value of the asset-backed commercial paper will reduce if the value of the underlying security reduces.

   Now, the creditworthiness of blue-chip corporations is not very likely to undergo a change within a short period of time. However, there is always a chance that the personal loan portfolio or the credit card portfolio of a bank may deteriorate in quality over a short period of time. This is the reason that there is a significant valuation risk involved.

3. Market Slowdown: Another major point to be considered is that there are several issuers of asset-backed commercial papers.

   In case, the valuation of a particular asset class slows down, then they might all want to sell off that same asset class at the same time. The end result will be that there will be no buyers for these securities and that their prices will plummet overnight. There is always the risk that a market-wide slowdown may negatively affect an investor’s position.

4. Complexity: It also needs to be understood that asset-backed commercial papers are a very complex type of securities. They have several cash flow patterns and also a lot of different types of credit enhancements.

   Hence, an individual investor does not have the expertise required to correctly value these complex securities. The inability to correctly value these securities also means that these securities are often incorrectly priced in the open market.

The bottom line is that asset-backed commercial papers are a very complex type of security. These securities serve a very specific purpose which investors must be aware of before they chose to invest their hard-earned money in them.

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