Investors in floating-rate home equity ABS should educate themselves on the changeable intricacies of the available funds cap (AFC) to which the coupons on these bonds are subject, according to a report from Banc of America Securities.
In order to hedge against increased exposure to AFC risk resulting from a greater percentage of fixed-rate bonds, most recent home equity securitizations contain imbedded interest rate corridors, or yield maintenance agreements, to guard against net WAC cap shortfalls. Such a mechanism is basically a cap contract whereby the counterparty's liabilities are limited by a maximum interest rate.
In the absence of excess funds allocated to reduce net WAC carryover amounts, the net coupon of the backing collateral will determine the AFC strike. Because floating-rate home equity bonds are often funded by a mix of fixed- and floating-rate collateral, the percentage of fixed-rate collateral funding the certificate is critical in evaluating the AFC risk.
The net WAC cap strike can differ from the net WAC of the collateral with the inclusion of IO tranches. "In this case, the net WAC cap strike is reduced proportionally to the current coupon and notional balance of the IO to compensate for the excess spread consumed by the tranche," analysts wrote. For example, deals that monetize excess spread with an IO tranche can decrease the net WAC cap strike by more than 100 basis points.
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