Asset-backed securities: Definition, types, and examples

Asset-Backed Securities

Asset-backed securities (ABS) are finance pools of familiar asset types, such as auto loans, aircraft leases, credit card receivables, mortgages, and business loans. In one way or another, these asset types represent contractual obligations to pay returns to investors. ABS provide a way for institutions to raise funds by converting illiquid assets into liquid securities.

What are asset-backed securities?

Asset-backed securities (ABS) are finance pools of familiar asset types, such as auto loans, aircraft leases, credit card receivables, mortgages, and business loans. In one way or another, these asset types represent contractual obligations to pay returns to investors. ABS provide a way for institutions to raise funds by converting illiquid assets into liquid securities.

These contractual obligations are typically more important than traditional debt obligations, which lowers the risk that investors may face for the borrowers. ABS also has many more investor-friendly options that can help mitigate losses and increase monetary reserves such as overcollateralization and diversity of payers. Unlike other structured credit models such as ABS, and structured bonds, some ABS offer better returns than similar rating corporate and city bonds.

Securitized Assets: Creating asset-backed securities

In order to form asset-backed securities, loans are grouped together in the form of securitization. Securitization can be made with various forms of loans, including residential and commercial loans. The interest and principal payments are passed to investors, while defaults are avoided because underlying asset-backed securities contain only fractions from each underlying asset. These pools of assets differ depending upon risk and return. Lower risk ones can come with reduced interest rates while more risky assets may yield greater returns.

Asset-backed securities, the commonly found type of securitized asset, are created when financial institutions bundle similar assets together, such as car loans, credit card debt, or mortgages. They then create securities that represent claims on the cash flows generated by these grouped assets. Finally, these securitized assets are sold to investors who receive returns based on the performance of the underlying assets.

What is the value of asset-backed securities?

The value of an asset-backed security is primarily determined by the cash flows generated from its underlying assets and its perceived associated credit risks. Let's run through a few of the key factors that influence the value of ABS:

  • Underlying asset quality: The value depends on the quality and performance of the assets in the pool. Higher-quality assets, or assets that hold minimal risk and produce strong results, generally result in higher-value ABS.
  • Cash flow stability: The predictability and reliability of cash flows from the underlying assets impact the value. A higher level of stability in this area typically enhances the value of ABS.
  • Credit risk: The risk that borrowers may default on their obligations naturally affects value. Higher credit risk lowers the value of ABS as investors will demand higher returns to compensate them from the additional risk.
  • Interest rates: Changes in interest rates can impact the value of ABS. For instance, rising interest rates may decrease the value of ABS with fixed interest payments, while falling rates might increase their value.
  • Market conditions: Broader market conditions and investor demand also influence ABS values. Market sentiment and economic conditions, whether it's positive or negative, can play an outsized role in how these securities are priced.
  • Tranching and structure: ABS are often structured in tranches, which are smaller pieces of the overall security that are divided up to help cut down on the inherited risk. That being said, these tranches come with varying levels of risk and return. The value of each tranche can differ based on its position in the structure and the level of risk it carries from the original security.

How are asset-backed securities traded?

If you're seeking to get in on asset-backed securities trading, but unsure how or where to actually begin executing trades, it's actually not too dissimilar to trading any other securities.

The primary market for trading ABS generally sees financial institutions issuing the securities when they need arises to raise capital. Investors purchase asset-backed securities directly from the issuer during the initial offering. After this first period, ABS can be bought and sold in the secondary market, which is where the most trading activity actually occurs.

Investors can trade asset-backed securities through a variety of platforms, including over-the-counter (OTC) markets or through specialized brokers and dealers. ABS are traded electronically on these platforms or through electronic trading networks that facilitate the trades between two or more parties.

The participants in the asset-backed securities market that you will generally see include a range of characters within the financial world. This includes institutional investors such as banks, insurance companies, and investment funds, as well as individual investors that get in on the action through their brokerage accounts.

Types of asset-backed securities

As previously mentioned, asset-backed securities come in various forms, each with distinct characteristics, benefits, and drawbacks. Certain investors may find favor or flaw in any of them, so it's entirely dependent on your preferences when choosing which one is your preference. With that in mind, let's take a look at a few of the most common asset-backed securities.

Auto loan ABS

The biggest segment of the ABS markets is auto financing. Auto finance firms are issued with securities which are secured by the underlying pool of car loan debt. Auto loan ABS are structured to provide returns based on the payments made by borrowers on their vehicle loans. Automobile borrowers with fewer incomes may be eligible for auto loan payments if they can afford a higher monthly payment. The deal is often structured to pay pro-rata or combinations of the two.

Those interested in auto loan asset-backed securities can count on a few selling points to attract them further, such as that they tend to have relatively stable default rates, which can lead to consistent cash flows, and the higher quality of the underlying consumer asset (automobiles) retains values better than other assets which can potentially reduce risk. But as with any trading instrument, it's not all upside. Potential drawbacks include the risk of defaults on the auto loans as well as the fact that auto values depreciate over time which may affect the value of the underlying asset pool.

Automobile loans are amortizable assets which means that the cash flow from auto loans ABS includes monthly interest payments, principal payments, and pre-payment. Prepayments risk for auto loans are significantly higher in ABS and home equity loans. Prepayment occurs only if the borrower has sufficient cash for repayment. Refinance is rarely possible at lower rates because cars depreciate faster than the loan balance, thus leaving collateral value lower than outstanding debts. The balance of such loans is normally small and the borrowers cannot save significantly by refinancing with less interest and therefore there is no incentive to refinanced.

Credit card receivables ABS

Since 1987, credit card debts have been one of the main benchmarks of the ABS markets. Credit card receivable-backed securities are supported by the outstanding credit card balances and the payments made by cardholders. These receivables are considered assets for a business, and can be used as collateral for loans.

Benefits of credit card receivables ABS include, for one, the high liquidity of credit card receivables. They provide a regular, dependable influx of cash as well as an increased level of diversification in your income. Predictability is rare as an investor, so being able to rely on this cash flow is inarguably quite valuable. As long as you manage the inherent risk that comes with possible defaults, credit card receivables asset-backed securities can be a promising investment.

Student loan ABS

Student loan asset-backed securities consist of a pool of student loans, which can include both federal and private student loans. These loans come with government guarantees which certainly reduce risk when you buy them. If you are a more cautious investor, this should grab your attention. Additionally, student loans are almost always in high demand, as there are always new students enrolling in colleges and applying for students loans to cover the expenses. As a result, student loan asset-backed securities tend to show relatively stable payment performance.

The downside to investing in student loan ABS is that students sometimes don't find jobs that allow them to repay their loans. You should monitor for poor market conditions when considering this type of asset-backed security, as it could greatly affect your chances of profitability. Another potential con is the changes in interest rates between student loans, which could affect the overall yield of student loan asset-backed securities.

What are the key risks associated with investing in asset-backed securities?

Investing in ABS involves several risks, some familiar to the average investor with others that are fairly unique to securitized assets.

Credit risk is the risk that the underlying assets will default or underperform, impacting the cash that will ultimately be available to pay investors. ABS are often rated by credit agencies, so you would be aware of what you're getting into and how likely you are (theoretically) to make good on your investment. Lower-rated securities carry higher risk, but often come with the prospect of greater rewards.

Prepayment risk is a slightly different type of red flag, more commonly found in mortgage-backed securities. This occurs when borrowers pay off their loans early (such as refinancing a mortgage), which reduces the initial expected cash flow and affects returns. Extension risk is actually the opposite, as an extension on a loan would cause borrowers to pay slower than expected. This would extend the duration of the ABS which, if interest rates were to rise, would potentially lead to lower returns as well. Two sides of the risk spectrum, equal opportunities for downside to your investment.

Other risks involving liquidity, the specific structure of the security (such as tranching as mentioned earlier), and market conditions are a bit more complex and a bit more out of your control, but can carry just as much weight. Do your best to understand how easily your securities can be sold, especially in less-than-ideal market conditions, and how exactly they're structured in order to avoid a precarious situation where your investment gets away from you.

What is the difference between ABS and MBS?

Asset-backed securities and mortgage-backed securities are both vital components of the modern financial landscape and, while possessing several qualities in common, provide investors with distinct opportunities for diversification within their portfolios. As the similar names imply, they are both types of securitized assets, but they differ fundamentally in their underlying collateral and risk profiles.

The main difference in these two types of securities is given away in the specificity of their names. MBS have a pool of mortgage securities sold to interested investors while ABS have a pool of a number of various other asset types. The ABS funds generally are supported in the form of credit cards and other debt that we've already mentioned previously in this article. Mortgage-backed securities can include commercial mortgages or residential mortgage loans, both an MBS is always signified by its underlying asset being a mortgage of some kind.

The liquidity risk associated with ABS and MBS varies considerably as a result of the different underlying assets that comprise the two securities. MBS are particularly sensitive to interest rate fluctuations; as rates rise, mortgage prepayments tend to decline, which in turn often affects the cash flows coming from MBS. Conversely, ABS may carry risks related to credit performance of the underlying loans, which can be tied to a range of economic conditions that impact consumers' ability to repay their debts. For example, a market downturn could lead to higher default rates on credit card receivables, which would surely leave a mark on ABS performance.

The markets for ABS and MBS also operate differently. MBS are often linked to government-sponsored enterprises, or GSEs, like Fannie Mae and Freddie Mac. GSEs such as these can provide a level of security and liquidity not typically found in the ABS market. This government backing can make mortgage-backed securities appealing to the more risk-averse investors out there. On the other hand, asset-backed securities can offer higher yields in return for involving riskier underlying assets, which of course will attract a different, more ambitious type of investor.

Another difference between asset-backed securities and mortgage-backed securities are in the investment strategies most often deployed for each of them. MBS investors tend to focus on the income generated from mortgage payments, while ABS investors may seek higher yields through diversified asset exposure. This more or less circles back to how the two securities attract distinct types of investors depending on their risk appetite, but understanding these differences is essential for making informed investment decisions when choosing between them.

Conclusion

Asset-backed securities are undeniable sources of diversification and liquidity for interested investors seeking to branch out from the traditional types of investing. These instruments, backed by a variety of underlying assets, allow issuers to access funding while enabling investors to earn returns that often surpass traditional fixed-income products.

However, the complexities and risks associated with ABS require careful analysis and due diligence prior to diving into them. As the financial landscape continues to evolve, understanding the nuances of asset-backed securities could provide more opportunities for savvy investors and issuers alike to expand their capacity for untapped profits.

FAQs

Is an ETF an asset-backed security?

No, but an ETF (exchange-traded fund) can hold asset-backed securities as part of its portfolio. ETFs are investment funds that typically tracks an index or a specific sector on the stock market. They can consist of various assets, one of which being an ABS, but it would be incorrect to place ETFs under the category of being an asset-backed security. They are distinct types of financial products with a decent level of overlap between them.

Are asset-backed securities derivatives?

ABS are not derivatives, as they are actual financial instruments that represent ownership of a pool of underlying assets. Derivatives, on the other hand, are financial contracts whose value is derived from the performance of an underlying asset, index, or rate. While ABS can be complex, they are fundamentally different than derivatives, as they are directly linked to the cash flows from the underlying assets as opposed to derivatives and their dependency on the performance of the asset on the market.

Is ABS the same in finance and accounting?

As we've established here, ABS stands for "asset-backed securities" within the financial world. In accounting, the acronym actually means something entirely different and unrelated. ABS in accounting means account and billing system, which is the software used to process invoices and manage any actions related to those invoices. While any confusion between the two can be understandable, they are certainly not interchangeable.

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