Bonds Backed by Student Loans Are at the Head of the Class

The world of asset-backed bonds (ABS) is in disarray. While home-equity securities have grabbed the headlines, other types of ABS have suffered as well. Student loan asset-backed bonds are one example of the baby being thrown out with the bath water.

There are two basic types of student loan ABS. Some are constructed with private student loans, and these carry risk of those borrowers failing to make payments. Others are made up of Federal Family Education Loan Program (FFELP) loans. FFELP loans are at least 97% guaranteed by the Department of Education (loans made before July 2006 have a greater guaranty).

Despite the guaranty, the yield spread on FFELP student loan bonds has widened substantially, creating an opportunity for investors looking for income securities that are not significantly exposed to credit risk.

A typical FFELP student loan securitization will include about five tranches. The first four will usually be labeled A1, A2, A3 and A4. These are all senior securities. The last tranch is a junior security, commonly called the B tranche. In the most recent Sallie Mae (SLM - commentary - Cramer's Take) student loan securitization, the B tranche represented 3% of the entire deal structure, exactly the amount uninsured by the federal government. This effectively eliminates credit risk for the senior securities.

The four senior tranches pay floating interest quarterly based on a spread to three-month LIBOR. The spread is set at issuance. In the secondary market, the bonds will trade at a premium or a discount to par based on the relative attractiveness of the original issue spread. Principal on these issues is paid sequentially, with all principal flowing to the A1 tranche until that tranche is completely repaid. Then all principal flows to A2 and so on. As a result, the tranches have very different average lives. Usually the A1 tranche has an average life of around one year. The average lives of the other tranches vary from deal to deal, but typically there is a three-year and a five-year tranche as well.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.