Here is how securitization helps reduce the risk of default on loans taken out by a borrower. These loans are repackaged into interest-bearing securities and sold to investors, thereby spreading the risk. This is also what a pass-through certificate, or PTC, does. This is a type of securitization in which investors receive interest but the final principal is dependent on repayment by the borrower. This operation is considered risky because investors risk not recovering the entire capital in the event of default by the borrower.
Historically, these PTCs were only held by institutions such as banks or mutual funds. However, some startups have now started offering them to retail investors. Wealth technology startup GripInvest, for example, sold PTCs and securitized debt instruments (SDIs) for a value ₹175 crore to retail investors on its platform in the last 12 months.
The securitization market in India has witnessed robust growth in recent years. For example, the annual aggregate for fiscal year 2023 exceeded ₹1.8 trillion, very close to the previous peak of ₹1.9 trillion in FY 2019. This trend highlights the growing popularity of PTCs and their position as a reliable investment choice for debt investors in India.
Listed PTCs are governed by regulations framed by market regulator Securities and Exchanges Board of India (Sebi) in 2008 on issuance and listing of SDIs and security receipts. Additionally, following statements made by the industry, in June, Sebi expanded the categories of instruments that can be distributed by online bond platform providers (OBPPs) to retail investors, and these now include SDIs, said Nikhil Aggarwal, Founder and CEO, Handle.
The securitization structure
Originators – often banks, non-banking financial companies (NBFCs) and factoring NBFCs – are responsible for raising capital for loans and receivables, thus forming the initial asset pool of the PTCs. Managers play a vital role in managing the loan portfolio, ensuring efficient recoveries. Importantly, they can be amended in cases where the originator faces financial difficulties, thereby protecting investors’ cash flows.
A special purpose vehicle (SPV), structured as a bankruptcy remote trust, holds the receivables and issues PTCs. Its main role is to protect the securitized assets from the financial health of the originator, thus strengthening investor protection. An independent administrator, appointed by the originator, oversees the operations of the SPV, ensuring compliance with regulations and protecting the interests of PTC holders.
Investors fund PTCs and receive cash flow generated from the underlying loan pool. They bring together various players, including banks, mutual funds, institutional investors and retail investors, seeking investment opportunities in securitized assets.
All PTCs offered by Grip are credit rated. The coupon rate attached to these instruments is generally a function of the credit rating issued for the PTC and is decided by reference to the coupon rates for similarly rated instruments (e.g. a similarly rated PTC or NCD) and the prevailing interest rate cycle. , Aggarwal added.
PTCs incorporate several inherent risk mitigation mechanisms. One of the key safeguards is the “skin in play” requirement, stipulated by the Reserve Bank of India (RBI), which requires the originator to invest a portion of its own capital, usually between 5% and 10%. , in the PTC. This contribution, known as the Minimum Retention Requirement (MRR), aligns the interests of the originator with those of investors, reinforcing their commitment to the quality and performance of the underlying assets.
“For factoring/invoice discounting operations, we have a notion of minimum replenishment time. Since the bills are short-lived, no capital is returned to investors during this period and the money is redeployed. Once the period ends, the proceeds are used to repay interest and principal to the senior tranche (investors) and then to the equity tranche (originator),” said Shantanu Bairagi, co-founder of Artfine Group.
Another risk-mitigating feature is “oversizing,” a structural feature that ensures each ₹100 invested, ₹110 of loans are securitized. This intentional overcollateralization acts as a protective cushion, providing investors with additional security in the event of default or losses within the loan portfolio.
PTCs also use “cash collateral” mechanisms, including bank guarantees or term deposit privileges marked in favor of the SPV by the originator. These guarantee provisions serve as financial guarantees, ensuring that sufficient funds are available to cover any potential shortfall in PTC payments.
Furthermore, “primary subordination” plays an essential role in risk management. In this configuration, the senior tranche (originator) only recovers the principal when the senior tranche (investors) has been fully paid. This subordination structure prioritizes the protection of investors’ capital, thus providing them with a higher degree of security.
Additionally, another element that makes PTCs an attractive option for retail investors is the potential for “excessive interest rate spread” (EIS). This represents the difference between the interest earned on the underlying loans and the interest paid on the PTC. For example, loans may carry a weighted average interest rate of 12%, while PTC carries a rate of 10%. The 2% difference serves as a buffer in the event of a default. In some cases, particularly when it comes to microfinance institutions, the EIS can be significant, reaching 12-15%. In the absence of default, EIS is earned by the equity or junior tranche as a reward for taking the risk of default.
Risks still exist
One of the main concerns is default or credit risk at the borrower level. Regardless of the rigorous selection criteria applied to borrowers, the inherent risk that some borrowers will default on their obligations remains. Such defaults can erode the effectiveness of collections, potentially leading to losses within the underlying loan portfolio.
Additionally, any originator/service provider bankruptcy presents a unique challenge. Although PTCs are issued by the SPV and are designed to be insulated from the financial health of the originator or manager, there are situations where the broader financial context may have an indirect impact on the investment. The recent case of Dewan Housing Finance Ltd (DHFL) notably illustrates how the seizure of term deposits given as cash collateral can lead to a downgrade of PTC’s rating, highlighting the importance of understanding these potential vulnerabilities. DHFL has been facing a financial crisis due to allegations of financial mismanagement and payment defaults, leading to serious liquidity problems and a downgrade in its credit rating. This has had a significant impact on the Indian financial sector.
Then there is the “liquidity and price risk” associated with PTCs in the secondary market. This risk arises from limited market liquidity, which makes it difficult to determine fair market prices for mark-to-market (MTM) calculations.
Cash flows are unpredictable if the underlying pool is retail loans due to possible prepayments and arrears. Thus, on payout dates, investors may receive cash flows that are higher or lower than expected cash flows. This variation typically does not occur when the underlying is a wholesale loan pool, said Ajinkya Kulkarni, co-founder and CEO of Wint Wealth.
In the case of factoring NBFCs, there is an additional level of risk associated with “operational creditors”. Receivables classified as operational debts can pose problems in the event of a billing default, as they may be considered subordinate to other creditors.
Bonds vs. PTC vs. P2P
Retail pool SDI/PTCs have some advantages over P2P or peer to peer lending. P2P platforms are online platforms that directly connect individuals to each other to facilitate transactions, without the need for a third-party intermediary. In the case of SDIs, investors know the underlying pool, which is reviewed and rated by a rating agency. It also has a built-in provision for loss absorption, so 15-20% of losses can be absorbed through credit enhancement. Access and liquidity are also easier since the shares are held in investors’ dematerialized accounts and listed on stock exchanges, Kulkarni added.
Diversification: Bonds represent unique instruments with limited diversification. PTCs aggregate thousands of loans for broad diversification, reducing individual loan risk. P2P platforms offer some diversification, but it is more limited than PTCs.
Risk Mitigators: Bonds vary in risk; Secured bonds provide security, unsecured bonds carry more risk. PTCs use risk mitigation mechanisms such as EIS, cash collateral and overcollateralization. In contrast, P2P platforms only have EIS.
Rating: Bonds reflect the creditworthiness of an issuer. PTCs are rated higher than creators due to structural protections. The P2P industry has only one classified player: Liquiloans,
Back: Bonds generate returns of 9-14% and are influenced by market conditions. PTCs offer yields of 10-13% based on the underlying loans. P2P lending yields range from 9 to 12 percent, determined by borrower rates and platform fees.
Who is it for ?
PTCs aimed at individual investors are still in their infancy. These are complex instruments that are intended only for sophisticated investors. Since interest payments are taxed at the flat rate, they do not benefit from any special tax benefits. It is also worth noting that the mortgage-backed securities that caused the 2008 financial crisis were similar to PTCs, although at a very broad level. Make sure you know what you’re getting into.