Asset-Backed Security (ABS): What It Is, How Different Types Work (2023)

What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables.It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Key Takeaways

  • Asset-backed securities (ABSs) are financial securities backed by income-generating assets such as credit card receivables, home equity loans, student loans, and auto loans.
  • ABSs are created when a company sells its loans or other debts to an issuer, a financial institution that then packages them into a portfolio to sell to investors.
  • Pooling assets into an ABS is a process called securitization.
  • ABSs appeal to income-oriented investors, as they pay a steady stream of interest, like bonds.
  • Mortgage-backed securities and collateralized debt obligations can be considered types of ABS.

Understanding Asset-Backed Securities (ABSs)

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can't be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans,or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren't available in any other investment.

How an Asset-Backed Security Works

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use tomake more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

Special Considerations

An ABS will usually have three tranches:class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by aspecial purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

(Video) Asset-Backed Security (ABS) 11380

  • Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
  • Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
  • Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt.
  • Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.
  • Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn't qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

A mortgage-backed security (MBS) is sometimes considered a type of ABS but is more often classified as a separate variety of investment, especially in the U.S. Both operate in essentially the same way; the difference lies in the underlying assets in the portfolio. Mortgage-backed securities are formed by pooling together mortgages exclusively, while ABSs consist of any other type of loan or debt instrument (including, rather confusingly, home equity loans).MBSs actually predate ABSs.

Auto Loan ABS

Car financing is another large category of ABS. The cash flows of an auto loan ABS include monthly interest payments, principal payments, and prepayments (though the latter is rarer for an auto loan ABS is much lower when compared to a home equity loan ABS). This is another amortizing loan.

Credit Card Receivables ABS

Credit card receivables—the amount due on credit card balances—are a type of non-amortizing asset ABS: They go to a revolving line of credit, rather than towards the same set sum. So they don't have fixed payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually alock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After thelock-up period, the principal payment is passed on to ABS investors.

Student Loan ABS

ABSs can be collateralized by either government student loans, guaranteed by the U.S. Dept. of Education, or private student loans. The former have had a better repayment record, and a lower risk of default.

(Video) Mortgage-Backed Securities (MBS) Explained in One Minute: Did We Learn Our Lesson?

An ABS will usually have three tranches:class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

What Is an Example of an Asset-Backed Security?

Acollateralized debt obligation (CDO) is an example of an asset-based security (ABS). It is like a loan or bond, one backed by a portfolio of debt instruments—bank loans, mortgages, credit card receivables, aircraft leases, smaller bonds, and sometimes even other ABSs or CDOs. This portfolio acts as collateral for the interest generated by the CDO, which is reaped by the institutional investors who purchase it.

What Is Asset Backing?

Asset backing refers to thetotalvalueof a company'sshares, inrelationtoitsassets. Specifically, it refers to thetotalvalueof all theassetsthat a company has,dividedby thenumberof outstandingsharesthat the company hasissued.

In terms of investments, asset backing refers to a security whose value derives from a single asset or a pool of assets; these holdings act as collateral for the security—"backing" it, in effect.

What Does ABS Stand for in Accounting?

In the business world, ABS stands for "accounting and billing system."

(Video) What are Asset Backed Securities? | Made in Germany

What Is the Difference Between MBS and ABS?

An asset-based security (ABS) is similar toa mortgage-backed security (MBS). Both are securities that, like bonds, pay a fixed rate of interest derived from an underlying pool of income-generating assets—usually debts or loans. The main difference is that an MBS, as its name implies, consists of a package of mortgages (real estate loans). In contrast, an ABS is usually backed by other sorts of financing—student loans, auto loans, or credit card debt.

Some financial sources do use ABS as a generic term, encompassing any sort of securitized investment based on underlying asset pools—in which case, an MBS is a kind of ABS. Others consider ABSs and MBSs to be separate investment vehicles.

How Does Asset Securitization Work?

Asset securitization begins when a lender (or any company with loans) or a firm with income-producing assets earmarks a bunch of these assets and then arranges to sell the lot to an investment bank or other financial institution. This institution often pools these assets with comparable ones from other sellers, then establishes a special-purpose vehicle(SPV)—an entity set up specifically to acquire the assets, package them, and issue them as a single security.

The issuer then sells these securities to investors, usually institutional investors (hedge funds, mutual funds, pension plans, etc.). The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the portfolio of assets.

(Video) What are Asset-backed securities (ABS)

Sometimes the issuer divides the original asset portfolio into slices, called tranches. Each tranche is sold separately and bears a different degree of risk, indicated by a different credit rating.

FAQs

What is an example of an asset-backed security? ›

A collateralized debt obligation (CDO) is an example of an asset-based security (ABS). It is like a loan or bond, one backed by a portfolio of debt instruments—bank loans, mortgages, credit card receivables, aircraft leases, smaller bonds, and sometimes even other ABSs or CDOs.

What are 4 asset types that are common to securitizations? ›

Securitized products are valued based on the cash flows of the underlying assets. Mortgages (residential and commercial), credit card receivables, auto loans, student loans, etc. can each be pooled together to create securitizations.

What are asset-backed securities used for? ›

Asset-backed securities (ABS) 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.

What is the difference between ABS and MBS? ›

Asset-backed securities (ABS) and mortgage-backed securities (MBS) are two of the most important types of asset classes within the fixed-income sector. MBS are created from the pooling of mortgages that are sold to interested investors, whereas ABS is created from the pooling of non-mortgage assets.

WHO issues asset-backed securities? ›

The loan originators are commonly referred to as the issuers of ABS, but in fact they are the sponsors, not the direct issuers, of these securities. These financial institutions sell pools of loans to a special-purpose vehicle (SPV), whose sole function is to buy such assets in order to securitize them.

What is asset security? ›

Asset security includes the concepts, structures, principles and standards aimed at monitoring and securing assets covering anything that can be important to the organization, such as partners, employees, facilities, equipment and information.

What is asset-backed risk? ›

An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized (or "backed") by a specified pool of underlying assets.

How are ABS rated? ›

Credit ratings for ABSs are established by reviewing the structure of the deal and the parties involved, the nature and performance history of the collateral, the special purpose entity used to securitize the collateral and issue the resulting notes, and by an analysis of the credit enhancements used to protect the ...

How do securitizations work? ›

Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.

What is an ABS transaction? ›

ABS Transaction means a securitization sponsored by the Originator, pursuant to which, the Originator sells Receivables to a special purpose entity which issues term securities backed by such Receivables in either a public offering or an offering pursuant to Rule 144A.

How are asset backed securities valued? ›

The value of the security is then equal to the present value of all of the cash flows. The security's value, assuming the cash flows are default-free, will equal the present value of the replicating portfo- lio of Treasury securities. In turn, these cash flows are valued at the Treasury spot rates.

How do I invest in asset backed securities? ›

If you decide you want to invest in an ABS, you can purchase one at almost any brokerage firm. If you work with a financial advisor, they can assist you in selecting the most suitable ABS for your portfolio and cash flow needs.

Is MBS a fixed-income security? ›

interest and principal. Mortgage-backed securities, called MBS, are bonds secured by home and other real estate loans.
...
Fixed-Coupon Bonds and Mortgage Bonds.
Fixed-Coupon BondsMortgage Bonds
Coupon is interest onlyCoupon is interest and principal
5 more rows

Is an ABS a derivative? ›

Asset-backed securities (ABS) are debt instruments collateralized by various loans and obligations. These are types of derivative instruments.

How many mortgages are in a MBS? ›

A typical MBS might consist of 1,000 or more mortgages with similar financial characteristics and risk profiles. There are two different types of mortgage-backed securities. Pass-throughs give you interest and principal payments proportional to your investment.

Are asset-backed securities structured products? ›

The most common Structured Finance products are mortgage-backed securities (MBS) and asset-backed securities (ABS) for auto loans, home equity loans, student loans, and credit card receivables.

What assets can be used by a company toward asset-backed loans? ›

Understanding Asset-based Lending

Examples of assets that can be used to secure a loan include accounts receivable, inventory, marketable securities, and property, plant and equipment (PP&E).

Are asset-backed securities floating rate? ›

Asset-backed securities have floating rate coupons. At times of rising interest rates and inflation, fixed rate instruments are likely to deliver negative returns, while floating rate instruments can offer some portfolio protection as coupons reset higher in line as central banks change policy.

What are the 4 types of assets? ›

Historically, there have been three primary asset classes, but today financial professionals generally agree that there are four broad classes of assets:
  • Equities (stocks)
  • Fixed-income and debt (bonds)
  • Money market and cash equivalents.
  • Real estate and tangible assets.
4 Mar 2021

What are 3 types of assets? ›

long-term assets.
  • Current Assets. Current assets are assets that can be easily converted into cash and cash equivalents (typically within a year). ...
  • Fixed or Non-Current Assets. Non-current assets are assets that cannot be easily and readily converted into cash and cash equivalents.
7 May 2022

What are different kind of security assets? ›

The four types of security are debt, equity, derivative, and hybrid securities. Holders of equity securities (e.g., shares) can benefit from capital gains by selling stocks.

How are asset backed securities traded? ›

The individual loans that underlie an ABS are typically illiquid and can't be sold on their own. However, once pooled and securitized, they become liquid and are freely traded in the open markets. The income that flows from the payments on the underlying loans is then used to compensate the holders of the securities.

Are asset-backed bonds safe? ›

The fact that property bonds are asset-backed, and typically secured by way of a first or second charge over the underlying asset, means there is an element of downside protection for investors.

What are asset backed securities PDF? ›

Asset backed securities (ABSs) are structured finance products backed by pools of assets and are created through a securitisation process.

How large is the ABS market? ›

Since 2009, 15 first-time issuers have accessed the ABS market, with total volume of approximately $6.7 billion.

Is debt considered a security? ›

How Debt Securities Work. A debt security is an investment asset that involves a debt rather than ownership in a company. A common example is when a corporation or government agency issues a bond and sells it to investors.

What is asset backed loan? ›

A loan against asset is a secured loan where a borrower pledges an asset as collateral. With this type of loan, the borrower can access a high loan amount at affordable interest rates. A borrower can avail of up to 80% of the asset value.

Who plays a big role in asset securitization? ›

The exhibit highlights the key roles in the securitization process: issuer, underwriter, rating agency, servicer, and trustee. 2 The issuer (sometimes referred to as sponsor or originator) brings together the collateral assets for the asset-backed security.

How many stages of securitization are there? ›

There are four steps in a securitisation: (i) SPV is created to hold title to assets underlying securities; (ii) the originator or holder of assets sells the assets (existing or future) to the SPV; (iii) the SPV, with the help of an investment banker, issues securities which are distributed to investors; and (iv) the ...

How does securitization make money? ›

Securitization is the process of pooling various forms of debt—residential mortgages, commercial mortgages, auto loans, or credit card debt obligations—and creating a new financial instrument from the pooled debt. The bank then sells this group of repackaged assets to investors.

What is Reg AB compliance? ›

Regulation AB consolidates and codifies existing interpretative, primarily client-specific, positions that clarify Securities Act of 1933 registration requirements for asset-backed securities offerings in the United States.

Which is an asset based financial service? ›

Asset-based finance, or ABF, is a collective term used to describe invoice finance, and asset-based lending. Invoice finance includes factoring, invoice discounting and supply chain finance. All of the four main forms of asset-based finance can be used to release cash flow for the business to use as needed.

What is a loan backed security? ›

Loan-backed securities (LBS) are bonds backed by a pool of loans. The types of loans can be car loans, credit card debt, student loans and even solar power loans, but they do not include mortgages.

What is asset based income? ›

Understanding Earning Assets

Earning assets include stocks, bonds, income from rental property, certificates of deposit (CDs) and other interest or dividend earning accounts or instruments. They can provide a steady income, which makes particularly useful for long-term goals such as retirement planning.

Is a mortgage an asset for a bank? ›

A home loan is an asset for the lender. The home loan payments are a form of accounts receivable that the lender expects to receive payment on. These receivables are secured by the property itself, which the lender maintains a lien on until the loan is repaid. This is how lenders make money.

Which is a disadvantage of securitization? ›

Disadvantages of securitisation

it can be a complicated and expensive way of raising long-term capital - though less expensive than full share flotation. it may restrict the ability of your business to raise money in the future.

What happens to MBS when interest rates rise? ›

Mortgages and MBS experience negative convexity. When mortgage rates go up, the price of MBS goes down by a greater amount than the price goes up when rates go down by the same amount. As rates fall, MBS prices go up less (compared to other bonds) because of refinancing, where the maturity of mortgages becomes shorter.

Does SEC regulate mortgage? ›

However, while the SEC regulates the disclosure provided to the investors in mortgage-backed securities, the SEC does not require that detailed information be provided regarding the individual loans or properties underlying the securities.

How do you make a short MB? ›

Shorting the Agency MBS Basis (“Short MBS Basis”)

In its most basic form, the Short Basis is implemented by shorting the current coupon TBA pass-through while going long a similar duration Treasury (e.g., short Fannie Mae 2.0% TBA vs long 7-Year U.S. Treasury).

Why is prepayment considered a risk? ›

Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When prepayment occurs, investors must reinvest at current market interest rates, which are usually substantially lower. Prepayment risk mostly affects corporate bonds and mortgage-backed securities (MBS).

What is the difference between a CMO and MBS? ›

A collateralized mortgage obligation, or CMO, is a type of MBS in which mortgages are bundled together and sold as one investment, ordered by maturity and level of risk. A mortgage-backed security, or an MBS, is a kind of asset-backed security that represents the amount of interest in a pool of mortgage loans.

Who creates the mortgage-backed security? ›

Most mortgage-backed securities are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises.

Why do investors buy mortgage-backed securities? ›

Mortgage-backed securities typically offer yields that are higher than government bonds. Securities with higher coupons offer the potential for greater returns but carry increased credit and prepayment risk, meaning the realized yield could be lower than initially expected.

Why do mortgage-backed securities fail? ›

Demand for mortgages led to an asset bubble in housing. When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spread the risk into every corner of the globe.

What are mortgage-backed securities are they safe Why? ›

A mortgage-backed security (MBS) is an investment secured by a collection of mortgages bought by the banks that issued them. Mortgage-backed securities are bought and sold on the secondary market. An MBS is a type of asset-backed security.

Can you lose money on mortgage-backed securities? ›

Types of mortgage-backed securities

But the bond's underlying loans may be refinanced, and investors are repaid their principal and lose the cash flow over time.

What happens when MBS defaults? ›

Traditional mortgages carry a fixed interest rate and a constant nominal monthly payment. If the borrower fails to make the required payments, they are in default and the lender may foreclose on the mortgage and take legal possession of the property.

Who owns the most mortgage-backed securities? ›

The Federal Reserve is the single largest agency MBS investor through its large-scale asset purchase program, with total holdings of $2.5 trillion as of October 2021.

Is a CDO an asset-backed security? ›

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).

Are asset-backed securities derivatives? ›

Asset-backed securities (ABS) are debt instruments collateralized by various loans and obligations. These are types of derivative instruments.

Are asset-backed bonds safe? ›

The fact that property bonds are asset-backed, and typically secured by way of a first or second charge over the underlying asset, means there is an element of downside protection for investors.

What is the difference between a CDO and an ABS? ›

Key Takeaways. An ABS is a type of investment that offers returns based on the repayment of debt owed by a pool of consumers. A CDO a version of an ABS that may include mortgage debt as well as other types of debt. These types of investments are marketed mainly to institutions, not to individual investors.

What is a CDO simple explanation? ›

CDOs, or collateralized debt obligations, are financial tools that banks use to repackage individual loans into products sold to investors on the secondary market. The value of CDOs comes from the promise of future repayments of the underlying loans.

What is a CDO and how does it work? ›

A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets. These underlying assets serve as collateral if the loan goes into default. Though risky and not for all investors, CDOs are a viable tool for shifting risk and freeing up capital.

How do you create an asset-backed security? ›

To create asset-backed securities, loans and other forms of debt are pooled together in a process known as securitization. Securitization can take place with many types of loans, such as commercial and residential mortgages, auto loans, consumer credit card debt, and student loans.

How do you buy asset-backed securities? ›

If you decide you want to invest in an ABS, you can purchase one at almost any brokerage firm. If you work with a financial advisor, they can assist you in selecting the most suitable ABS for your portfolio and cash flow needs.

How are asset-backed securities valued? ›

The value of the security is then equal to the present value of all of the cash flows. The security's value, assuming the cash flows are default-free, will equal the present value of the replicating portfo- lio of Treasury securities. In turn, these cash flows are valued at the Treasury spot rates.

What assets can be used by a company toward asset backed loans? ›

Understanding Asset-based Lending

Examples of assets that can be used to secure a loan include accounts receivable, inventory, marketable securities, and property, plant and equipment (PP&E).

What does ABS stand for in finance? ›

Asset-backed securities, also called "ABS," are pools of loans that are packaged and sold to investors as securities—a process known as “securitization.”1 The type of loans that are typically securitized includes home mortgages, credit card receivables, auto loans (including loans for recreational vehicles), home ...

Are property bonds a good investment? ›

If you are seeking an investment that protects your capital, by securing it against assets, property bonds may be an ideal opportunity for you. Property bonds can be a very attractive investment opportunity for any prospective high net worth individual, sophisticated investor, self-certified investor.

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