12.6 Split Shares & Asset-Backed Securities
Key Takeaways
A split share corporation holds a portfolio of shares and issues preferred shares (fixed dividends, priority on capital) and capital shares (residual value and leveraged upside).
Capital shares magnify gains and losses in the underlying portfolio; preferred shareholders are protected by asset coverage.
Asset-backed securities are created when a pool of loans or receivables is sold to a special purpose entity that issues securities backed by the pool's cash flows.
Tranching gives senior classes first claim on cash flows; junior and equity tranches absorb losses first.
Canada's 2007 non-bank ABCP crisis showed the liquidity, complexity and transparency risks of asset-backed products.
Structured products repackage the cash flows of underlying assets to create securities with different risk and return profiles. Principal-protected notes and market-linked GICs were covered earlier; this section covers split shares and asset-backed securities.
Split Share Corporations
A split share corporation buys a portfolio of common shares (often a group of Canadian banks or other dividend payers) and finances it by issuing two classes of shares, usually sold together as units:
| Class | What holders receive | Risk profile |
|---|---|---|
| Preferred shares | A fixed (or reset) dividend and a fixed redemption amount at termination; first claim on the portfolio | Lower risk, protected by asset coverage |
| Capital (Class A) shares | Whatever is left after the preferred shareholders are paid: remaining dividends plus all capital appreciation | Higher risk, effectively leveraged |
Most split share corporations have a set termination date, when the portfolio is sold and the preferreds are redeemed first. Many suspend distributions on the capital shares if the portfolio's net asset value per unit falls below a set level, to protect the preferred shareholders.
Worked Example: The Leverage in Capital Shares
A split share corporation holds $20 of bank shares for each unit. Each unit consists of one preferred share with a $10 redemption value and one capital share.
- Starting point: capital share value = dollars; preferred asset coverage = times.
- Portfolio rises 20% to $24: capital share value = dollars, a gain of 40%.
- Portfolio falls 20% to $16: capital share value = dollars, a loss of 40%; preferred coverage falls to times.
A 20% move in the portfolio produces a 40% move in the capital shares: the preferred shares act like borrowed money for the capital shareholders. If the portfolio fell below $10 per unit, the capital shares would be worthless and the preferreds would not be fully repaid.
Taxation: the corporation passes through Canadian dividends (eligible for the dividend tax credit) and capital gains. Risks include concentration in a few issuers, leverage for the capital shares, distribution suspensions, and early redemption or extension of the termination date.
Asset-Backed Securities (ABS)
Securitization turns illiquid loans into tradable securities. The steps are:
- An originator (a bank, finance company or retailer) makes loans or generates receivables: credit card balances, auto loans, equipment leases, mortgages or trade receivables.
- It sells a pool of these assets to a special purpose entity (SPE), often a trust, which separates the assets from the originator's own credit.
- The SPE issues asset-backed securities, which are paid from the pool's cash flows.
Tranching and Credit Enhancement
ABS are usually issued in tranches with different priorities:
| Tranche | Priority | Typical rating |
|---|---|---|
| Senior | Paid first; last to absorb losses | AAA or high investment grade |
| Mezzanine | Paid after senior | Lower investment grade |
| Equity (first-loss) | Paid last; absorbs losses first | Unrated, often kept by the originator |
For example, a $100 million pool might fund $80 million of senior notes, $15 million of mezzanine notes and a $5 million equity piece. If the pool suffers $8 million of losses, the equity tranche is wiped out ($5 million) and the mezzanine tranche loses $3 million, while the senior notes are untouched.
Other credit enhancements include overcollateralization (the pool is larger than the securities issued), reserve accounts, excess interest spread, and third-party guarantees. Government-backed mortgage securities (NHA MBS and Canada Mortgage Bonds) are a special case because CMHC guarantees them.
Common Asset Types
- Credit card receivables: major Canadian banks fund part of their card balances through credit card trusts that issue term notes.
- Auto loans and leases: banks and the finance arms of car makers securitize car loans and leases.
- Equipment leases and dealer floorplan loans: financing for businesses and car dealers.
- Residential mortgages: NHA MBS, guaranteed by CMHC, are by far the largest Canadian securitization market.
Covered bonds are a related bank funding tool. They are obligations of the issuing bank and are also backed by a ring-fenced pool of mortgages, so investors have a claim on both (dual recourse). Unlike most ABS, the assets stay on the bank's balance sheet.
Who Should Hold ABS?
Most ABS are sold to institutional investors that can analyze the collateral and structure; retail investors usually gain exposure through bond funds. Before recommending any asset-backed product, an advisor must understand the collateral, the tranche's place in the payment priority, and how easily the security can be sold.
The 2007 ABCP Crisis
Asset-backed commercial paper (ABCP) is short-term paper issued by conduits that hold longer-term assets. In August 2007, the Canadian market for non-bank-sponsored ABCP froze: investors stopped rolling over the paper, the liquidity backstops did not work as expected, and the underlying assets were complex and opaque. About $32 billion of paper was frozen until it was restructured into longer-term notes under the Montreal Accord. The crisis led to tighter rules for short-term debt exemptions and greater attention to liquidity, complexity and conflicts in structured products.
Key ABS risks: credit risk of the underlying borrowers, prepayment risk (especially for mortgages), liquidity risk, model and rating risk, and the complexity of the structure.
A split share corporation holds $30 of shares per unit and has preferred shares with a $12 redemption value. If the portfolio rises 10%, by how much does the capital share value rise?
10.0%
12.5%
16.7%
25.0%
In an asset-backed securities structure, which tranche absorbs credit losses first?
All tranches share losses equally
The senior tranche
The equity (first-loss) tranche
The mezzanine tranche
What was a central lesson of the 2007 freeze in Canada's non-bank asset-backed commercial paper market?
Opaque, highly rated short-term paper can suddenly become illiquid
Split share corporations must hold only bonds
Government of Canada treasury bills carry high default risk in a crisis
Asset-backed securities are insured by CDIC
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