Within the EMEA consumer and auto asset-backed securities (ABS) markets, most transactions have typically followed a sequential amortization profile, where repayment of the most senior note takes priority over that of the junior notes. Over recent years however, the trend has shifted, with more transactions featuring pro rata amortization coming to market than in previous years.

In this report, S&P Global Ratings discusses the different pro rata set-ups we have observed, the risks introduced by these features, and the approach we have typically used to rate these transactions in the past.

Frequently Asked Questions

What are the main types of pro rata transactions in EMEA ABS?

We have primarily rated transactions with two types of pro rata amortization. Some transactions immediately start amortizing on a pro rata basis, where the entire capital structure amortizes pro rata. Others start paying on a sequential basis but then switch to pro rata payment once credit enhancement builds-up to a specified amount, allowing the transaction to amass additional credit enhancement after closing. Generally, both types of pro rata amortization feature performance triggers which, if breached, would irrevocably revert amortization to sequential.

What are the incentives for issuers utilizing pro rata structures?

Pro rata structures reduce the weighted-average cost of funds, making this feature attractive to issuers. In pro rata transactions, cost of funds remains constant over the transaction's life, whereas in sequential pay the cost of funds increases as the senior notes are paid down first, which have a lower coupon.

In addition, junior noteholders may value this feature as they receive their principal payments earlier compared with a transaction paying sequentially.

What are the main risks of transactions with a pro rata feature and how are they typically mitigated in our cash flow analysis?

In our view, pro rata amortization is credit negative for the most senior notes. A pro rata feature would simultaneously amortize principal on all notes in the capital structure while maintaining credit enhancement levels as a percentage of the outstanding pool balance. On the other hand, transactions with sequential repayment would increase the credit enhancement percentage for senior notes over the transaction's life, all else equal. Therefore, pro rata features can increase tail-end risk--the risk of defaults occurring later in the transaction's life.

In our analysis of these transactions, if losses are back-loaded after a benign environment, collections and excess spread have already been used to pay down junior notes or have simply been paid out of the structure, therefore less credit enhancement remains for the most senior notes compared with a sequential amortization profile, all else equal. Furthermore, transactions with balloon or residual value risk, which typically have a larger exposure to losses at the end of their life given the maturity profile of the receivables, are more sensitive to pro rata features.

Usually, transactions will introduce triggers to mitigate tail-end risk, preventing principal from flowing to junior notes if breached. Some of the most common triggers we have seen include:

• Performance triggers: if defaults or delinquencies exceed a certain threshold, the transaction will switch to sequential repayment. Typically, the default trigger is cumulative and increases over time, becoming a static figure after a certain period. The trigger can be based on either net or gross losses. Given that a gross loss trigger would be breached earlier than a net loss trigger due to delays in recovery timing, it would generally provide relatively more protection to senior notes in a pro rata structure since the release of principal to junior notes would be curtailed earlier. Moreover, the tightness of the trigger as defined in the transaction documents compared to observed defaults affects the likelihood of the trigger being breached.
• Clean-up call: some transactions may feature mandatory sequential repayment if the outstanding portfolio balance falls below 10% of the original balance.
• Principal deficiency ledger (PDL) trigger: for transactions where there is a PDL mechanism to capture excess spread on the interest waterfall, if the PDL trigger on the most junior note is breached, the transaction will automatically switch to sequential.
• Other triggers, including originator or servicer insolvency.

However, not all pro rata transactions are exposed to the same level of risk. In our view, transactions starting on a sequential basis that then switch to pro rata only after certain credit enhancement levels have been reached present lower tail-end risk. These transactions direct initial interest and principal payments to build-up credit enhancement after closing until it switches to pro rata, while transactions that pay pro rata from closing do not build up additional credit enhancement for the senior notes.

How do we analyze ABS pro rata transactions in EMEA?

To assess the effect of concentrated defaults later in the transaction's life once excess spread is depleted and principal has been released to junior notes, and as described in our "Global Auto ABS Methodology And Assumptions," and our "Global Consumer ABS Methodology And Assumptions" criteria, we may apply a slower loss curve in our analysis for transactions featuring pro rata amortization. In addition, for transactions where pro rata payment starts at closing, or it isn't preceded by a meaningful sequential period, we may also delay the loss curve start date.

For example, in transactions we have rated that become pro rata after target credit enhancement has been met, we have typically applied a back-loaded curve, while for transactions starting pro rata immediately after closing we have typically applied a six-month delay to the loss curve start in addition to the back-loaded scenario to capture the effect on prepayments and release of enhancement. Where we delayed the recession starting date, we have usually also delayed the timing of certain seller risks--such as commingling or set-off risk--as we did not anticipate these risks taking place during the benign environment preceding the recession.

In surveillance, to mitigate the risk of a pro rata amortization profile, we have typically considered back-loaded default patterns. To the extent that the transaction we surveilled would have already been amortizing for a year and considering the typically shorter weighted-average life (WAL) of ABS transactions, we typically have not considered the six months delayed loss curve start date.

Below we can observe the different loss curve distributions that may be applied in our analysis. Although the level of losses is unchanged, the timing differs.

Chart 1

Appendix

Out of the 96 ABS transactions we rate, 26 have a pro rata amortization feature. Below is the list of transactions we currently rate with a pro rata amortization profile. Note that we have only considered auto, consumer, and equipment lease transactions.

Table 1

Related Criteria And Research

• European Auto ABS Index Report Q3 2022, Nov. 7, 2022
• Economic Outlook Eurozone Q4 2022: Crunch Time, Sept. 26, 2022
• Global Auto ABS Methodology And Assumptions, March 31, 2022
• Global Consumer ABS Methodology And Assumptions, March 31, 2022
• Global Framework For Payment Structure And Cash Flow Analysis Of Structured Finance Securities, Dec. 22, 2020