Pass-Through Certificates (PTCs) are debt instruments backed by tangible assets such as loans and receivables. The underlying assets are transferred to a Special Purpose Vehicle (SPV) or Trust.
This SPV/Trust then issues the certificates to investors, allowing them to receive cash flows generated by those assets. These loans may include vehicle loans, microfinance receivables, housing loans, or other retail credit originated by banks and Non-Banking Financial Companies (NBFCs). A PTC is a securitised debt instrument that gives investors a proportional share in the cash flows generated by a pool of underlying loans. So, let’s first understand securitisation for a better understanding of PTC.
Concept of Securitisation
Securitisation is a process where financial institutions convert loans into tradable securities. Instead of waiting years for borrowers to repay, banks package groups of loans and transfer them to a separate entity called a Special Purpose Vehicle (SPV).
The SPV then issues securities backed by these loan repayments, which investors can buy.
- For banks: It provides immediate liquidity, allowing them to issue more loans.
- For investors: It offers access to returns from a diversified pool of loans.
- For borrowers: Their repayment schedule remains unchanged.
In essence, securitisation transforms illiquid loans into marketable investment products.
For example, a bank, NBFC, or housing finance company may hold a large portfolio of loans that borrowers repay over several years. While these loans generate steady cash flows, the lender may need funds immediately.
So, the lender transfers a pool of loans to a SPV, which is a legal entity. The SPV issues securities backed by the expected loan repayments and sells them to investors. The proceeds are passed on to the lender.
Borrowers continue making principal and interest payments, which are collected and distributed to investors. This allows lenders to access funds earlier while giving investors exposure to loan-based cash flows.
What are Pass-Through Certificates?
A pass-through certificate is a securitised debt instrument that represents a proportional ownership interest in a pool of underlying loans. Cash flows from borrowers, including principal repayments and interest, are distributed to PTC holders after deducting permissible expenses such as servicing fees.
Unlike a regular bond, where the issuer pays a fixed coupon from its own resources, a PTC's cash flows depend on the performance of the underlying loan pool. If borrowers in the pool default, the cash flows to PTC holders may decrease.
A PTC is also distinct from a Non-Convertible Debenture (NCD). With an NCD, the issuer is directly obligated to make payments. With a PTC, cash flows are linked to actual borrower repayments within the pool.
How do Pass-Through Certificates Work?
The following is a step-by-step breakdown of how a typical PTC transaction is structured and executed.
- Step 1: The originator (an NBFC, bank, or housing finance company) identifies a pool of performing loans from its book. These may include vehicle loans, microfinance loans, or housing loans.
- Step 2: The originator transfers this loan pool to a SPV set up specifically for the transaction. The transfer is generally structured as a true sale, with the objective of achieving legal separation of the assets from the originator and making them available for securitisation.
- Step 3: The SPV issues PTCs to investors. These certificates represent a proportional claim on the cash flows from the loan pool. The issuance may be structured into senior, mezzanine, and junior tranches.
- Step 4: A trustee is appointed to oversee the SPV and protect investor interests. The trustee ensures that cash flows are distributed correctly and that transaction terms are honored.
- Step 5: A servicer, often the originator itself, collects payments from the underlying borrowers and passes them to the SPV, which then distributes them to PTC holders.
- Step 6: An independent credit rating agency assigns ratings to each tranche based on asset pool quality and the level of credit enhancement.
Key Participants in a PTC Transaction
The following are the key participants involved in a pass-through certificate transaction.
Originator
The entity that originated the underlying loans and transfers them to the SPV.
SPV
The bankruptcy-remote entity that holds the assets and issues the PTCs.
Trustee
The independent entity that manages the SPV and safeguards investor rights. The trustee may replace the servicer if collections falter.
Servicer
The entity responsible for collecting borrower payments and passing them to the SPV.
Investors
Banks, mutual funds, insurance companies, and qualified institutional buyers who purchase the PTCs.
Benefits of Pass-Through Certificates
The following are a few benefits of pass through certificates:
Capital Recycling for Originators
PTCs allow NBFCs and other lenders to convert illiquid loan portfolios into immediate capital. This supports fresh lending activity and keeps credit available within the broader economy.
Portfolio Diversification
PTC investors gain exposure to a diversified pool of underlying loans instead of relying on a single borrower. This distributes credit risk across a large number of borrowers, which may help reduce concentration risk.
Periodic Cash Flows
PTCs generate periodic cash flows based on borrower repayments. Senior tranche holders receive scheduled payments before other tranches. These cash flows are subject to borrower performance and are not guaranteed.
Bankruptcy-Remote Structure
Because assets sit inside an SPV, they are legally separated from the originator. Even if the originator faces financial distress, PTC investors' claim on the asset pool may remain intact, subject to actual collections from borrowers.
Risks of PTCs
The following are a few key risks associated with investing in pass through certificates.
Credit or Default Risk
If borrowers in the underlying pool default, cash flows to PTC holders may decrease. Junior and mezzanine tranche holders absorb these losses first. Senior tranche holders can also be affected if defaults exceed the level of credit enhancement.
Interest Rate Risk
Changes in prevailing interest rates can affect the market value of PTCs. When rates rise, the market value of existing fixed-rate PTCs may experience a price correction. This is particularly relevant for longer-tenure pools.
Limited Secondary Market Liquidity
PTCs do not trade as actively as government securities or corporate bonds on Indian exchanges. Exiting a PTC position before maturity can be difficult, and bid-ask spreads may be wide.
Prepayment Risk
Borrowers in the underlying pool may repay their loans ahead of schedule. While this returns capital to PTC holders sooner, it may also reduce the total interest income received over the life of the certificate.
Macroeconomic Risk
A broad economic slowdown can increase default rates across the entire loan pool. Sectors such as microfinance or vehicle loans can be particularly sensitive to economic cycles, which may affect cash flows.
Credit Enhancement and Tranching
Credit enhancement is a set of structural features designed to reduce the risk for PTC investors. These features create a buffer that absorbs losses before they reach the investor.
There are two broad types. Internal credit enhancement includes mechanisms like overcollateralisation, where the value of the loan pool exceeds the value of the PTCs issued against it. Cash collateral and excess interest spread also fall into this category. External credit enhancement might involve a third-party guarantee.
Tranching is the process of dividing the PTC issuance into layers, each with a different risk and return profile. This allows investors with different appetites to participate in the same deal.
Senior, Mezzanine, and Junior Tranches
| Feature | Senior Tranche | Mezzanine Tranche | Junior Tranche |
|---|---|---|---|
| Payment Priority | First to receive cash flows | Second in line | Last to receive cash flows |
| Risk Level | Lowest | Moderate | Highest |
| Indicative Yield | Lower | Moderate | Higher |
| Typical Credit Rating | AAA / AA | A / BBB | Unrated or lowest rated |
| Loss Absorption | Protected by subordinate tranches | Absorbs losses after junior tranche | First to absorb losses |
The senior tranche holds the first claim on cash flows and is protected by the mezzanine and junior tranches beneath it. The junior tranche absorbs the first losses.
Role of PTCs in Securitisation in India
PTCs play a central role in India's securitisation market by facilitating the transfer of cash flows from loan pools to investors. They serve as the primary instruments through which banks, NBFCs, and housing finance companies securitise assets such as vehicle loans, housing loans, and microfinance receivables.
For originators, PTC transactions help improve liquidity and release capital from existing loan portfolios. This helps improve liquidity, optimise balance sheet utilisation, and support additional lending activity. PTCs have also been an important funding avenue for NBFCs, particularly during periods when access to traditional sources of funding has been constrained.
From an investor perspective, PTCs provide exposure to diversified pools of underlying loans and their associated cash flows. By connecting originators with institutional investors, PTCs facilitate the movement of capital within the financial system and support the availability of credit across different sectors of the economy.
The growth of the Indian securitisation market, supported by the RBI's regulatory framework, has reinforced the importance of PTCs as a key component of structured finance transactions in the country.
Special Considerations
The following are a few structural and regulatory aspects of PTCs that are worth understanding:
The RBI mandates that originators retain a minimum percentage of every securitised pool on their own books. As per the RBI's Master Directions on Securitisation of Standard Assets (2021), originators are required to retain a minimum stake in securitised assets. The Minimum Retention Requirement is generally 5% or 10% of the book value of the loans being securitised, depending on the characteristics of the underlying assets. This requirement is designed to keep the originator's interests aligned with those of investors.
The MRR also establishes a Minimum Holding Period (MHP). The originator must hold the loans on its books for a specified period before they can be securitised. This measure reduces the risk of loans being originated purely for the purpose of quick resale.
Conclusion
Pass-through certificates are structured finance instruments that allow investors to participate in the cash flows from a pool of underlying loans. They play an important role in India's securitisation market, particularly as a funding mechanism for NBFCs and housing finance companies. However, PTCs carry distinct risks, from borrower defaults to limited secondary market liquidity, that differ from those of regular bonds or NCDs.
Investors may consider examining the credit rating of each tranche, the composition and geographic spread of the asset pool, the level of credit enhancement, the originator's servicing track record, and compliance with RBI's MRR and MHP norms before evaluating any PTC investment.
FAQs on What are Pass-Through Certificates (PTCs)
What is a pass-through certificate in simple terms?
A pass-through certificate is a financial instrument that gives the holder a share of the cash flows from a pool of loans. A lender bundles its loans, sells them to an SPV, and the SPV issues PTCs. As borrowers repay their loans, the principal and interest pass through to the certificate holders.
How are PTCs regulated in India?
PTCs in India are regulated primarily by the RBI under its Master Directions on Securitisation of Standard Assets (2021).
What are the main risks of investing in PTCs?
The main risks include credit risk, interest rate risk, limited liquidity in the secondary market, and prepayment risk.
What is the difference between a PTC and a direct assignment?
In a PTC transaction, loans are transferred to an SPV, which issues certificates to multiple investors. Tranching and credit ratings apply. In a direct assignment, loans are sold directly from the originator to a single buyer without an SPV, tranching, or a formal credit rating.
Who can invest in pass-through certificates in India?
PTCs are primarily available to institutional investors such as banks, mutual funds, insurance companies, and qualified institutional buyers. Retail investor access is limited, although some categories of PTCs may be available through specific platforms or structured products. Eligibility depends on the terms of each issuance and the applicable regulatory framework.
Disclaimer:
The information contained in this Article (“Article”) is for general informational purposes only. Northern Arc Capital Limited (“Northern Arc”) does not make any warranties about the completeness, reliability, and accuracy of this information. Any action you take upon the information contained in this Article is strictly at your own risk, and Northern Arc will not be liable for any losses and damages in connection with the use of our Article.
The data included in this Article has been obtained from sources that are believed to be reliable and accurate at the time of publication. However, Northern Arc does not guarantee the accuracy or completeness of any information, nor does it assume any responsibility or liability for any errors or omissions therein. Any opinions expressed herein are subject to change without notice and Northern Arc is under no obligation to update or keep current the information contained in this Article.
This Article is not intended to constitute, and should not be construed as, investment advice or a recommendation to purchase, sell, or hold any security or to engage in any investment strategy or transaction. Readers should not rely solely on the information provided in this Article for making investment decisions and should conduct their own due diligence or seek the advice of a qualified professional.
The content of this Article is for informational purposes only and is not a solicitation or an offer to buy or sell any securities or financial instruments. Northern Arc is not responsible for any investment decisions made by the recipients of this Article. Readers should take independent financial advice from a qualified professional in connection with, or independently research and verify, any information that is provided in this Article and wish to rely upon, whether for the purpose of making an investment decision or otherwise.
Northern Arc and its affiliates, directors, employees, and agents expressly disclaim any and all liability for any direct or indirect losses, damages, or expenses of any kind arising out of or relating to the use of this Article, including but not limited to, any losses related to the accuracy, completeness, timeliness, or reliability of such information.
This Article may contain forward-looking statements that are based on current expectations, estimates, forecasts, and projections about the markets in which Northern Arc operates, as well as management’s beliefs and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results.
This report is intended solely for the recipient and is not for further circulation. Any distribution, modification, reproduction, or disclosure of the contents of this Article, in whole or in part, without the prior written consent of Northern Arc, is strictly prohibited.