Corporate Finance For Dummies
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When several of a single type of asset or, sometimes, several different types of assets are grouped together and sold collectively as a single security, that’s called bundling.

Bundling has come to have a unique role in corporate finance since the start of the 21st century. The actual act of bundling involves taking several different assets and lumping them together in something called an asset pool with a nominal value equivalent to the sum of the values of the individual assets included.

The issuer takes the total value of the assets or their future cash flows and sells equity backed by this value wherein either ownership in the asset itself or its cash flows will generate returns. The source of derived value is similar to that of a stock or a bond, respectively.

The thing that makes bundling significantly different from standard securitization is the matter of risk. The risk adjusted value is higher than the sum of the individual assets.

Because bundling, by its very nature, creates a certain amount of inherent diversification within the security (if one of the assets in the pool fails, there are others that are still valid), the risk of the bundle must be measured as a unique set in itself. This is done by classifying each individual asset by its risk level, and then taking the weighted average of the different classifications present within the bundle.

Pass-through certificates

Easily the most common example of bundling for a single type of asset is something called a pass-through certificate. Sold by mortgage lenders, these securities derive their value from the future cash flows generated as borrowers pay back their mortgages.

So, the lender issues several mortgages, bundles them together into an asset pool, and sells securities to raise money and distribute the risk associated with that asset pool to the investment community. Investors earn returns by receiving long-term payments in the form of principal and interest repayments. The process isn’t really all that different from securitization except you’re creating securities out of an aggregate of assets rather than a single asset.

In a pass-through certificate, the credit risk level of each individual mortgage is classified in a manner similar to the way Moody’s or the S&P measures the risk of bonds. The credit ratings of the individual assets are then used to develop a weighted average risk for the entire portfolio. Here’s an example:

Sample simple pass-through: A, A, A, B, C
Weighted average risk: B+

Multi-asset bundles

Another, slightly different, form of bundling includes bundling multiple, different types of assets together. Mutual funds are a common example of this type of bundling, because they frequently group together different types of equities, bonds, and other forms of assets into a single pool.

Investors then purchase shares of ownership in the mutual fund itself. As opposed to a hedge fund, where people give their money to someone who then manages their cash as a pool, mutual funds are pools of assets in which people invest.

Because the risk of each individual asset in these multi-asset bundles (compared to single-asset bundling) isn’t measured in the same way, nor does each asset often have the same type of risk, the risk of these bundles is measured a bit differently.

These bundles are actually very similar to investment portfolios; in a way, they’re investment portfolios that have been securitized. As a result, the most effective method to assess the risk of these bundles is to measure them the same way you would an investment portfolio.

Unbundling assets

Another innovation related to bundling comes into play when a single security is broken into several different securities, in a process called unbundling. This term usually refers to the process by which the cash flows from a single security, such as a bond, are broken apart and each is sold as a different security.

For example, a coupon bond that makes interest coupon payments as well as principal repayment at maturity can be broken into several different types of securities. The issuer can bundle the individual coupon payments into a single security to be sold on its own, while the principal repayment at maturity is sold separately.

Each security is treated as a separate investment with its own valuation, pricing, cash flows, and ability to be sold and resold; but both securities derive their value from the same underlying asset — a single bond or pool of cash flows from coupons or principal repayments.

This form of unbundling is still lagging in popularity compared to bundling, though it holds just as much potential to be applied to any sort of investment that generates cash flows over time. The cash flows from a single mortgage can be unbundled, not only by the types of cash flows, as with unbundled bonds, but also with regard to their repayment periods.

This process makes several new types of investments from a single mortgage, each with a differing level of risk not only from credit risk, but also from interest rate risk: The longer the repayment period on the security, the higher the interest rate risk.

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Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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