What is Early Amortization?
Early amortization is an accelerated payment of bond principal to investors holding asset-backed security (ABS) products. Early amortization is also called an early call or a payout event.
How Early Amortization Works
Early amortization reduces the amount of time before an investor will receive the repayment of their principal from an asset-backed security (ABS) purchase. Typically, when an investor purchases a bond, they receive regularly scheduled interest payments over a set period, or until the maturity of the bond. At the point of bond maturity, the investor gets back the full value of the bond principal and interest payments cease.
Asset-backed securities (ABS) are financial securities that are collateralized by a pool of underlying assets such as loans, leases, credit card debt and other receivables. For example, a bank might bundle car loans on which they collect interest and sell them to finance future car loans. Assets like these are usually illiquid and can be hard to sell on their own accord. However, the process of securitization makes them marketable to investors as bundling these assets can spread the risk out over a large portfolio.
Early amortization will mean a liquidity crisis for the bond originator, as funding dries up. The event is usually triggered if there is a sudden increase in delinquencies in the underlying loans. Other early amortization triggers for asset-backed securities include:
- The bond’s sponsor, such as a bank, or servicer declaring bankruptcy
- Insufficient payments from underlying borrowers
- Inadequate excess spread, or low remaining interest payments and other collected fees on the security after covering expenses
- Default rate rises above an acceptable level
When early amortization occurs, it cannot be reversed or rescinded, and all bond principal and interest payments go to investors regardless of a bond’s expected maturity date.
How Early Amortization Affects Investors
Rating agencies typically require asset-backed securities to include language in their contracts about early amortization to receive a debt rating. This language is needed because the payout from an early amortization event helps protect investors from prolonged exposure to receivables with deteriorated credit performance. Investors should be aware that while early amortization helps mitigate the risks involved with investing in asset-backed securities, it does not eliminate it. There is still the risk that investors will not earn all of the promised interest from the security if an early amortization event is triggered.
The cash flow of asset-backed securities is not always reliable. For that reason, they are not sold with a guaranteed maturity date, but instead, with an average maturity. Early amortization can help protect investors if the bond’s maturity is cut short.