Through innovative deal structuring, asset-backed transactions are increasingly being used as principal protection mechanisms, where the interest rate is correlated to something unrelated to the underlying assets.

Salomon Smith Barney recently closed its third such transaction, a $40 million deal called Tiers Principle-Protected Asset-Backed Certificates Trust Series Telecom 2000-7. The coupon, which pays at the end of the five-year term, is based on the Amex Telecom index.

"Over the last two years, particularly, we've seen a growing number of equity-linked and index-linked transactions," said Chris Howley, a director on the deal at Standard & Poor's Ratings Services.

An investor looking for this type of product would be an investor looking for exposure to the telecom index, sources said. Interestingly, the bonds are sold to retail as well as institutional investors, which in itself is a rarity for asset-backeds.

"For institutional and smaller retail investors who are looking for this type of risk, with principle protection, this is the type of instrument that would fulfill both of those parameters," a source said.

Salomon has done two similar transactions, a $27 million, S&P 100-indexed deal last December, and a $90 million, Nasdaq-indexed deal in April. Each of the transactions is backed by a triple-A-rated pool of credit-card receivables.

Tax Break

Though diversified exposure and principal protection are two incentives for the deal, a tax deferral mechanism is built into the transaction.

For one, the deals are structured so that investors are able to avoid paying "phantom" income taxes or taxes on a yearly basis without receiving any cash distributions.

Since the trust pays the income it receives on its assets to a swap counterparty - in this instance, Salomon Smith Barney - the payment is considered an expense and not income under the tax laws.

"The payment to the swap counterparty completely offsets the income of the trust," explained Matthew Mayers, a vice president at Salomon who developed the structure for the deal.

"Therefore the trust does not have any income during the term of certificates, and the certificate holders should not receive or recognize income for tax purposes prior to maturity," Mayers added.

Further, the payment at maturity is considered a capital gain as opposed to ordinary income, which is another tax advantage.

"Any rational investor who's concerned about tax consequences might buy our product over the equity-linked products issued by our competitors through their medium term note programs, because investors must pay phantom income taxes with those products and any gain on the sale or at maturity will be ordinary income," Mayers said.

Rating the Deal

For measuring risk, the rating agencies look at the previously rated underlying collateral, which, in the Amex deal, is the triple-A-rated credit cards, and the swap counter party, or Salomon Smith Barney.

"We use a weak link approach," said John McCarthy, an analyst at S&P. "In this case, the rating is dependent upon the underlying collateral, the cash flow coming from the swap counterparty and permitted investments."

What happens also, in the event that the underlying credit cards pay out more than the eligible interest determined by the Amex telecom index, the excess is reinvested in eligible investments. Return off the eligible investments would go to certificate holders.

What the rating agency is not rating is the likelihood that the investor will receive a positive coupon based off the index, McCarthy said.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.