What is an Asset-Backed Security (ABS)?
An asset-backed security (ABS) is a sophisticated financial instrument backed by a pool of income-generating assets, such as loans, leases, credit card debts, or receivables. Designed in the form of bonds or notes, ABS provides fixed-income payments over time until they mature, offering a compelling alternative for income-focused investors to traditional corporate bonds or bond funds.
Why ABS? Key Takeaways
- Income-Generating Assets: ABS consists of assets like credit card receivables, auto loans, student loans, and home equity loans.
- Securitization Process: Issuers sell their receivables to institutions that pool them into marketable ABS portfolios.
- Investors’ Benefits: These securities afford a steady income stream akin to bonds, attracting income-oriented investors.
- Enhanced Flexibility: ABS investments allow exposure to a wide range of income-generating assets, from conventional to exotic.
- Diverse Categories: Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) are notable types of ABS.
Understanding the Mechanics of ABS
ABS serves a dual role: allowing issuers to convert illiquid assets into cash, and offering investors a diversified income stream. By pooling various debts like auto loans, home equity loans, and even niche assets such as royalty payments or toll roads, ABS issuers create marketable securities that appeal to a range of investors.
The Securitization Process: This involves converting pools of illiquid assets into tradable securities, thus mitigating the credit risk for the issuer while providing revenue streams for investors.
Engaging Example: How an ABS Comes to Life
Imagine Company AutoFinance offers loans for purchasing vehicles but needs more cash to continue its operations. AutoFinance bundles its outstanding loans and sells them to an investment firm. This firm then organizes these loans into groups called tranches based on characteristics like interest rate and maturity date. They issue securities for each tranche. Investors who buy these securities will receive the cash flows derived from the auto loan repayments, net of the firm’s fees.
Dive into the Types of Asset-Backed Securities
Collateralized Debt Obligations (CDOs)
A CDO is a type of ABS issued by a Special Purpose Vehicle (SPV) - a designated business entity formed to issue ABS backed by diversified asset portfolios, such as CLOs (collateralized loan obligations), CBOs (collateralized bond obligations), and more.
Home Equity ABS
Home equity loans package borrower payments, often from borrowers with lower credit scores. These loans provide threefold payment categories: interest, principal, and prepayments.
Auto Loan ABS
Auto loans aggregated into ABS provide revenue streams from monthly interest and principal payments, though prepayments are less common compared to home equity loans.
Credit Card Receivables ABS
Credit card receivables ABS handles debt that accumulates on a revolving credit line. Unlike amortizing loans, these do not have fixed payments, allowing dynamic inclusion of new loans.
Student Loan ABS
Student loan ABS can be derived either from government-guaranteed loans or private student loans. The former tends to exhibit better repayment behavior and lower default risks.
Special Considerations in Tranches
An ABS commonly comprises three tranches: A, B, and C:
- Class A: Largest and lowest risk tranche, attracting investment-grade buyers.
- Class B: Higher yield with lower credit quality.
- Class C: Often retained by the issuer due to its risk level.
A Real-Life Example of ABS
A classic example of ABS is a CDO (collateralized debt obligation), backed by a wide array of assets from bank loans to real estate receivables. Buyers receive periodic income, supported by the underlying pooled assets.
Exploring Asset Backing
Asset backing refers to a company’s asset value divided by its outstanding shares, indicating security value backing. In investment terms, this means the security is supported by asset pools backing the derived income.
Comparing ABS and MBS
ABS and MBS both promise a fixed interest derived from pooled debt. The distinction? MBS are exclusively funded by real estate loans; ABS is underpinned by various other loans like student or auto loans. Some see MBS within ABS; others treat them as separate entities.
The Journey of Asset Securitization
The process commences when businesses bundled similar, income-generating assets and sell them to an investment entity. This entity, in turn, packages these assets into securitized financial instruments available to investors. Tranches of varying risk levels and credit ratings provide layers of investment options.
The Bottom Line
ABS stands robust as a key opportunity for massive institutional buyers, providing a consolidated income stream and asset class diversification. Comprising varied underlying assets, from everyday auto loans to less trodden paths like utility bills, ABS enriches portfolios while promising potentially outsized returns, given their higher risk profiles compared to typical bonds.
Related Terms: securitization, mortgage-backed securities, collateralized debt obligations, capital markets, credit risk.
References
- U.S. Securities and Exchange Commission. “Asset-Backed Securities”.
- Financial Industry Regulatory Authority. “Bonds: Types”.
- Guggenheim Investments. “The ABCs of Asset-Backed Securities (ABS)”.
- Professor Ian Giddy’s Finance Resources on the Web; New York University, Leonard N. Stern School of Business. “The CDO Product”. Pages 4-5.
- Andrew C. Spieler, Greg Filbeck, and H. Kent Baker (Editors). “Debt Markets and Investments”. Pages 392, 421-424, 429. Oxford University Press, 2019.
- National Association of Insurance Commissioners. “Collateralized Debt Obligations (CDOs); February 2019 Presentation”. Page 3.
- Andrew C. Spieler, Greg Filbeck, and H. Kent Baker (Editors). “Debt Markets and Investments”. Pages 384, 403. Oxford University Press, 2019.
- National Association of Insurance Commissioners. “Consumer Asset-Backed Securities Primer”. Pages 2-3.
- Federal Deposit Insurance Corporation. “Credit Card Securitization Manual”.
- Sallie Mae. “Asset-Backed Securities”.
- Bailey, Samantha L. and Ryan, Christopher J. “The Next ‘Big Short’: COVID-19, Student Loan Discharge in Bankruptcy, and the SLABS Market”. SMU Law Review, vol. 74, June 2020, pp. 839-841. Download PDF.
- National Association of Insurance Commissioners. “Collateralized Debt Obligations (CDOs); February 2019 Presentation”. Pages 3-5.
- Andrew C. Spieler, Greg Filbeck, and H. Kent Baker (Editors). “Debt Markets and Investments”. Pages 421-424, 429. Oxford University Press, 2019.
- Andrew C. Spieler, Greg Filbeck, and H. Kent Baker (Editors). “Debt Markets and Investments”. Pages 365, 369-375, 377. Oxford University Press, 2019.
