What are pass-through certificates and how do they work?

On a Sunday morning, sipping a cup of coffee, Rahul and his wife Pooja were discussing their financial goals and, as a periodic activity, reviewing their investment portfolio; they always believed that a well-diversified investment portfolio is integral to financial planning and were seeking to diversify beyond traditional options such as stocks, bonds, real estate, gold, FDs, etc.

On discussing further, they recalled Pass-Through Certificates (PTCs) suggested by their wealth manager in their previous meeting. They decided to read the frequently asked questions (FAQs) guide to help understand this financial product better.

What are PTCs and how do they work?

As per the Securities Contract Act, PTCs are debt instruments with rights over assets backed by cash flows. There are various types of underlying tangible assets of pass-through certificates, such as home loans, auto loans, microfinance loans, commercial loans, trade receivables, and so on.

Commercial or consumer credits are sold to a Special Purpose Bankruptcy Vehicle (SPV/ Trust), which in turn issues the debt instruments to the investors. This process is known as securitisation. In simple terms, PTCs are certificates given to investors against issued securities. Investors have proportionate rights over the assets (owned collectively by a Trust) and earn returns.

PTCs as an alternative high-yield investment option for HNIs

High Net Worth Individuals (HNIs), Ultra HNIs, and institutional investors with high ticket sizes tend to look for alternate investment avenues with higher yields. Pass-through certificates are emerging financial products that help investors achieve their goals. 

Here are a few key features why HNIs and institutional investors can opt to invest in PTCs:

Short-term investment avenue: Investors looking for a flexible short-term tenure of 6 - 12 months can park their surplus funds in Pass-Through Certificates.

Regulatory compliance: The securities fall under the purview of RBI and/or SEBI securitisation act which protects investors’ rights. The recent guidelines aim to enhance transparency, promote risk-based pricing, and improve market depth.

Strong Risk mitigants: In most debt products like NCD or FD, the risk depends on a single originator; for example, bonds/NCDs repayment depends on the issuing corporate entity. Whereas PTCs have assets that are backed by cash flow from a pool of well-rated buyers housed in a bankruptcy remote vehicle hence decoupled from the originator risk. In addition, certain credit enhancements, like cash margin etc., can be provided to safeguard the investors’ interest.

Better returns: Pass-through certificates (PTCs) have the potential to yield higher returns than conventional investment instruments such as fixed deposits, recurring deposits, debt mutual funds, etc., in similar risk categories.

Reading the benefits, Rahul and Pooja decided to dive deeper and read the illustration below to know how technology is being leveraged to make these instruments investor friendly:

1. Easy access to information: Investors can have access to transaction documents online like information memorandum, asset performance and characteristics
2. Seamless Execution: All subscription-related documentation signing can be done online
3. Instruments are issued digitally in dematerialized form, making them easier to transfer.

As a matter of caution, investors must consider the following checklist before investing:

• Go through the information memorandum, teasers and other issue-related documents in detail to understand the risk and reward.
• If the instrument's rating is available, it becomes a key indicator of the risk involved.
• Evaluate the legal remedies available to the investors in case of default, which is usually covered in the legal opinion issued for the transaction.
• Understand taxation-related deductions associated with the instruments.

Key takeaways

After in-depth research, Rahul and Pooja inferred that these instruments offer investors an opportunity to diversify their investments into non-traditional asset classes, increase the probability of earning higher returns, and hedge against market volatility. Post removal of long-term capital gains on debt instruments, these instruments become attractive options given high returns with moderate risk.

Shantanu Bairagi is the Co-Founder of Artfine