A hurricane leaves the insurance industry with $20 billion in insured losses on coastal property. Your cat bond pays Secured Overnight Financing Rate (SOFR) plus 6.5%. The question is not whether you lose principal. It is which trigger type determines your payout, and whether the collateral trust survived its own counterparty exposure. In 2008, that second question mattered for investors in four Lehman-sponsored cat bonds.
Asset-based lending ties the loan amount directly to collateral rather than to the borrower's cash flow or credit rating. The lender calculates a borrowing base by applying advance rates to each category of eligible collateral.
The typical ABL borrower is a small or midsize company. Loan sizes range from $10 million to $50 million, with some significantly larger. Borrowers operate across retail, distribution, manufacturing, wholesale, and services. The defining trait is an asset-rich balance sheet, with half or more of total assets sitting in working capital (inventory and accounts receivable).
Borrowers select ABL over cash-flow lending for two reasons. First, cash-flow lenders apply a multiplier to earnings before interest, taxes, depreciation, and amortization (EBITDA), which contracts in downturns and shrinks...
Common mistakes
- Misstating ABL advance rates. Receivables run 70% to 85% (90% with credit insurance), and inventory is 80% to 90% of liquidation value, not of book value. If a question states its own advance rates, use them: these terms are negotiated and vary widely across borrowers.
- Confusing prepayment risk with default risk. Prepayment risk concerns unscheduled principal repayment, partial or full, at an unexpected time. You get principal back sooner than expected, and if rates have fallen, you reinvest at lower rates. Default risk means the borrower does not pay. Treating the two as interchangeable produces wrong answers.
- Reversing the basis risk / moral hazard tradeoff. Indemnity triggers give the sponsor essentially no basis risk (payout matches actual losses) but carry more moral hazard (the hedged sponsor may underwrite excessive risks). Parametric triggers keep moral hazard low but expose the sponsor, and investors, to basis risk. Memorizing the table backwards flips every comparison.
Bottom line
- Asset-based borrowing base equals eligible collateral times advance rates: receivables 70-85% (90% with credit insurance), inventory 80-90% of liquidation value (not book), equipment discounted on liquidity. Past-due receivables and incomplete work-in-process are excluded, and senior claims reduce the base.
- The typical ABL borrower is small to midsize, asset-rich, and noninvestment-grade; loans run $10-50M, chosen because asset values are less volatile than EBITDA multiples across cycles.
- An ABL facility pairs a revolver with a term loan (3-5 years); seasonal overadvance covers working-capital spikes, traditional overadvance funds LBOs, and lenders typically emphasize fixed-charge coverage and liquidity rather than a net-leverage covenant.
- ABL carries five specialized risks: collateral valuation, process and people, hedging, legal (attachment and perfecting security interest), and exit timing.
Exam shortcut
When you see a cat bond question, immediately ask: "Which trigger type?" Then apply the indicative tradeoffs. Indemnity gives the sponsor essentially no basis risk but more moral hazard. Parametric keeps moral hazard low but leaves basis risk that depends on hedge design and exposure. If the question describes payout based on actual sponsor losses, it is indemnity.
The full lesson (about 11,469 words, 76 min read) adds 2 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- strategies
- credit risk bankruptcy
- bonds loans
- direct lending
- mezzanine
- advanced mezzanine
- venture debt
- distressed debt
- infrastructure debt
- asset based lending
- abs risks
- abs
- mortgage overview
- residential mortgages
- mortgage reit returns
- cat bonds
- cat trigger types
- cat valuation
- structuring overview
- cmos
- cdo intro
- cdo variations
- cash flow vs market value cdo
- other cdos
- cdo risks
- credit enhancements
- credit deriv markets
- cds
- cds index
- other credit derivs
Browse all free CAIA Level I lessons or jump into free CAIA Level I practice questions.