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Asset-backed securities are a sort of financial investment that is backed by a collection of underlying assets, typically ones that produce a cash flow from debt, such as loans, leases, credit card balances, or receivables. The issuer can make illiquid assets marketable to investors and lower their credit risk by pooling these assets and turning them into a financial instrument, a process known as securitization.
Asset-backed securities take the form of bonds or notes, paying income at a fixed rate for a set amount of time, until maturity. Asset-backed securities can provide an alternative to traditional debt products, such as corporate bonds or bond funds, for income-focused investors. While asset-backed securities are susceptible to various kinds of risks than conventional fixed-income instruments are, they can also benefit from diversification.
The underlying assets of an ABS can vary widely, depending on the issuer and the market demand. Some common examples of assets that can be securitized into an ABS are:
- Home equity loans: Loans that allow homeowners to borrow against the equity in their property.
- Automobile loans: Loans that finance the purchase of new or used vehicles.
- Credit card receivables: The outstanding balances that credit card holders owe to the card issuer.
- Student loans: Loans that finance the education expenses of students.
- Other expected cash flows: Any cash-producing vehicle or situation can be securitized into an ABS, such as movie revenues, royalty payments, aircraft landing slots, toll roads, or solar photovoltaics.
To create an asset-backed security, the issuer follows these steps:
- A special purpose vehicle (SPV), a company established only to hold assets and issue securities, is purchased by the issuer from whom loans or other debts were issued.
- The assets are combined into a pool by the SPV, which then splits them into tranches, or slices, according to their risk and return characteristics. The varied seniority levels among the tranches give some of them precedence over others when it comes to receiving cash flows from the underlying assets.
- Each tranche is backed by securities that the SPV issues and markets to investors. Depending on how well the underlying assets perform, the SPV will periodically pay the investors capital and interest.
- The servicer, which is in charge of obtaining payments from the borrowers and distributing them to the SPV, receives money from the SPV. Any defaults or delinquencies on the underlying assets are also handled by the servicer.
- Selling their loans or other debts to an SPV enables them to swiftly and effectively raise cash.
- They can shift the investors' credit risk for their assets, which will help their balance sheet and credit score.
- By issuing securities with interest rates lower than their own debt, they can reduce the cost of their finance.
The main benefits of asset-backed securities for investors are:
- A diverse array of assets that occasionally offer higher returns than other fixed-income securities can be used by them to provide a consistent flow of income.
- Depending on their level of risk tolerance and investing goals, they can choose from a variety of tranches of assets with various risk and return profiles.
- Credit enhancements that shield them from losses in the event of the underlying assets' default, such as over-collateralization, subordination, insurance, or guarantees, might be advantageous to them.
Asset-backed securities are not without risks, however. Some of the risks that investors face when investing in ABS are:
- Prepayment risk: Risk that the borrowers would pay off their debts earlier than anticipated, which will lower the investors' interest income.
- Extension risk: The possibility that borrowers would repay their loans later than anticipated, extending the assets' maturity and putting investors at risk of rising interest rates.
- Liquidity risk: Risk that because of low trading volume or market disruptions, investors won't be able to sell their assets in the secondary market quickly or at a fair price.
- Credit risk: Losses for the investors could result from the possibility that the borrowers will stop making payments or that the underlying assets' credit rating would decline.
