Structured asset investment loan trusts are a type of investment vehicle that pools various assets such as mortgages, auto loans, or credit card debt and issues securities backed by those assets. They have become an increasingly popular way for investors to gain exposure to consumer debt obligations. However, structured asset investments also carry risks. In this article, we will use some examples to illustrate the key features and risks of investing in a structured asset loan trust.
Structured investment trusts can generate steady cash flows but face prepayment risk
Structured loan trusts holding mortgages or other assets with scheduled principal repayments can generate a steady cash flow stream for investors. However, they face the risk that asset prepayments may occur faster than scheduled, reducing expected returns. For example, homeowners may refinance and prepay mortgages faster when interest rates decline.
Senior tranches offer safety while junior tranches offer higher yields
Structured loan trusts typically carve up cash flows into tranches of varying seniority. Senior tranches get first claim on payments and thus have less default risk. Junior or subordinate tranches have higher default risk but offer higher yields. An investor choosing a junior tranche is making a bet that defaults will not be severe enough to impair payments.
Diversification across loans can reduce credit risk
A benefit of structured investment vehicles is the diversification they offer across hundreds or thousands of underlying loans. This diversification can reduce credit risk relative to investing in individual loans. However, diversification benefits decline if the underlying assets are concentrated in a particular sector or geographic region.
Lack of liquidity can be an issue
Structured loan investments are usually sold through private placements with restrictions on resale. Thus, structured investments tend to be less liquid than traded bonds. Investors have to hold them to maturity unless a buyer can be found for an assignment of the investment. The illiquidity poses risks if investors require access to capital.
Complex structures pose analytical challenges
The complexity of structured investment vehicles can make analysis challenging for individual investors. Key risks including default correlation across underlying assets may be difficult to assess. This opaqueness underscores the need for adequate due diligence before investing in a structured loan trust.
In summary, structured asset loan trusts allow investors to gain exposure to consumer debt obligations, generate cash flow, and benefit from diversification. However, they also come with risks such as prepayment uncertainty, illiquidity, and analytical complexity. Thorough due diligence is key before investing.