What it means
A trust is a legal arrangement in which a trustee holds assets for the benefit of others. A trust certificate is the evidence of that benefit.
It is not usually a claim on a company's general finances, but a claim on the specific assets and cash flows held by the trust. One common form is the pass-through certificate used in asset-backed securities.
A trust holds a pool of assets such as car loans, and the payments from borrowers pass through the trust to the certificate holders, after fees. The holders carry the risk that borrowers pay late or default.
Another form is the equipment trust certificate, long used to finance railway carriages and aircraft. The trustee holds legal title to the equipment and leases it to a company, and the lease payments service the certificates, which can make them relatively safe because the equipment is security.
Islamic finance also uses trust certificates, known as sukuk, where holders share in the income of an underlying asset. This lets investors earn a return from rent or profit instead of interest.
For investors, the key things to understand are what the trust owns, how cash is shared out and how the certificates rank. Some are senior and are paid first, while others are subordinated and absorb losses first, in return for a higher yield.
The offering documents set out these rules. Compared with a bond, a trust certificate's payments depend on the performance of the assets inside the trust, not on the promise of a company to repay.
This makes the quality of the pool, the trustee's independence and the legal structure especially important.
In practice
Real-world examples.
Example
A bank groups $400,000,000 of car loans into a trust and sells certificates to pension funds. The funds receive monthly payments from borrowers, passed through the trust after fees. The bank removes the loans from its balance sheet and can lend the freed-up money again.
Example
An airline finances a new aircraft by selling equipment trust certificates. The trustee owns the plane and leases it to the airline, and the lease payments are used to pay the certificate holders.
Example
A government in a Muslim-majority country raises money by issuing sukuk trust certificates linked to the rental income of public buildings. Investors receive a share of the rent instead of interest. The structure is reviewed by religious scholars before the issue, and the trustee holds the buildings' rights for the investors.
Formula
Calculation
Distribution per certificate = (Cash collected - Fees) / Number of certificates
A trust holds a pool of auto loans and issues 10,000 certificates. In one month it collects $1,200,000 in interest and principal from borrowers. It pays a trustee fee of $12,000 and a servicing fee of $60,000.
Cash available = 1,200,000 - 12,000 - 60,000 = $1,128,000. Distribution per certificate = 1,128,000 / 10,000 = $112.80. A holder of 50 certificates therefore receives 50 x 112.80 = $5,640 for the month.Case study
Seen in the real world.
Tidewater Rail Leasing is an illustrative, fictional company that needed $80,000,000 to buy 400 freight wagons. Rather than borrow on its general credit, it set up a trust that bought the wagons and issued certificates to investors.
The trust leased the wagons back to Tidewater, and the lease payments of $1,000,000 a month covered the certificates' returns and the trustee's fee. Because the wagons were security, investors accepted a lower yield than on Tidewater's unsecured bonds, saving the company about 1.2 percentage points a year.
The illustrative lesson is that structure affected price, and that investors paid for the comfort of a physical asset behind their money. If Tidewater had defaulted, the trustee could have repossessed and re-leased the wagons, which investors valued, but the company also gave up flexibility because the equipment was tied to the trust.
Watch out
Common mistakes.
- Treating a trust certificate as an ordinary company bond, when payments depend on the assets held in the trust.
- Ignoring the ranking of the certificates, when a junior class may absorb losses before a senior class, which many investors only discover after reading the offering document too late.
- Assuming the trustee guarantees payment, when the trustee normally only administers the trust.
Questions
People also ask.
What does a trust certificate give the holder?
A share in the trust's income and assets according to the trust documents, not ownership of the underlying assets directly.
Who issues trust certificates?
Banks, finance companies, airlines, railways and governments, usually through a trust set up for the purpose, so that the assets are kept apart from the sponsor's other creditors.
Are trust certificates safe?
Their risk depends on the assets, the structure and the ranking, so they can range from very safe to very risky. Investors should read the offering document and check any credit ratings, which are opinions and not guarantees.
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