A two-wheeler loan pool yields 14%. The senior bonds pay 8.5% on 85% of the pool, servicing costs 1% and expected losses are 2.5%. How much excess spread is there, and what does it protect?

Excess spread is about 3.28% of the pool a year: 14% of yield, less 7.225% of senior coupon, 1% of servicing and 2.5% of expected losses. It is the first line of defence. Losses can run to about 5.8% a year, more than twice what is expected, before the 15% junior tranche is touched, and only after that does the senior investor lose. It shrinks if high-yield loans prepay or default, or if it is paid out rather than trapped.

From the gap between what borrowers pay and what the structure has to pay out. The loans earn 14% on the whole pool. The senior coupon costs only 8.5% on 85% of the pool, 7.225% of the pool, because the junior 15% carries no fixed coupon. Take off servicing of 1% and expected losses of 2.5%, and 3.275% of the pool is left each year. A landlord who collects Rs 14,000 of rent, pays Rs 7,225 of loan instalments, Rs 1,000 to an agent and sets aside Rs 2,500 for repairs has Rs 3,275 left over each month to cover surprises.

Losses above what was expected. Each month, losses are paid first out of excess spread, so annual losses can rise from 2.5% to about 5.8% of the pool before any of it eats into the junior tranche. Only when the junior 15% is used up does the senior investor lose principal. Over a pool whose loans run off in about two years, excess spread adds roughly 6.6 points of protection on top of the 15%, which is why rating agencies treat it as credit enhancementProtection that absorbs losses before they reach a given tranche, such as subordination, excess spread or a cash reserve. alongside subordination.

Three things. If the highest-rate loans prepay or default first, the pool's average yield falls while the senior coupon stays, so the spread compresses just when losses are rising. If the senior coupon floats and rates rise, the same happens from the other side. And if the structure releases excess spread to Dwiveda every month, it protects only against that month's losses; a trigger that traps it in a reserve account when losses cross a threshold turns it into a cushion that builds up. A senior investor should read the documents for exactly that trigger. The limitation: 2.5% expected losses is Dwiveda's history, and a pool of new-to-credit borrowers can lose far more in a downturn.