Excess Spread
Definition
The difference between interest collected from underlying assets in an ABS pool and interest owed to bondholders plus servicing fees and expenses. Excess spread acts as first-loss protection, absorbing charge-offs and delinquencies before subordination is eroded. In credit card ABS, excess spread typically runs 5-10% annually during normal conditions.
Why it matters
Excess spread is the primary credit enhancement mechanism in revolving ABS structures like credit cards and some auto loans. Unlike CLOs (where subordination is primary protection), credit card ABS rely heavily on excess spread to absorb ongoing charge-offs. When excess spread falls below minimum thresholds (often 0-2%), early amortization triggers, fundamentally changing deal dynamics. Understanding excess spread dynamics explains why credit card ABS performed differently than CLOs during 2008—charge-offs consumed excess spread, triggering early amortization, while CLOs diverted cash flows but continued revolving.
Technical details
Excess spread calculation
Excess Spread = (Gross Portfolio Yield) - (Investor Coupon + Servicing Fee + Losses). Example: Credit card portfolio yielding 18% APR. Bondholders receive 4% coupon. Servicing fee 2%. Monthly charge-offs annualized at 6%. Excess Spread = 18% - (4% + 2% + 6%) = 6% annualized. This 6% excess spread is available to absorb additional losses, build reserves, or pay subordinated tranches. If charge-offs spike to 10%, excess spread falls to 2%. If they reach 12%, excess spread turns negative and bonds begin experiencing losses (or early amortization triggers).
Excess spread accounts and reserves
Many ABS structures trap excess spread in reserve accounts rather than immediately distributing to equity. Typical structure: excess spread flows to cash collateral account up to target level (often 2-5% of outstanding bonds), then excess flows to subordinated tranches or equity. Reserve account provides cushion during temporary stress—if one month has high charge-offs consuming all current excess spread, reserve account covers the shortfall. This prevents immediate senior bondholder impact from monthly volatility. Reserve accounts filled first, depleted last.
Early amortization triggers based on excess spread
Credit card and revolving ABS typically trigger early amortization if excess spread falls below threshold for consecutive months. Common trigger: 3-month average excess spread below 0%, or excess spread below -2% for any single month. When triggered, trust stops purchasing new receivables and uses collections to pay down bonds. This protects bondholders from continued losses but eliminates equity distributions. Monitoring excess spread trends is critical for early warning—declining from 8% to 4% over 6 months may indicate growing stress even without formal trigger.