Asset-Backed Security (ABS)

5 mins read
by Angel One

Examining Investments Today – A Brief Overview

Financial markets presently offer a wide range of securities that can be invested in order to potentially generate returns in the future. Some of these offerings consist of products that have collateral made up of an underlying set of assets. Take for instance asset-backed securities. This article seeks to shed light on what they are, how they operate and the special considerations that govern their functioning.

Looking at the Asset-Backed Securities Meaning

Those responsible for issuing asset-back securities (or ABSs) do so in order to raise cash such that they can use the same to lend further or for alternative investment purposes. Oftentimes the underlying assets that constitute an ABS in finance tend to be illiquid and aren’t capable of being sold independently. By bringing together a set of assets and forging a financial instrument from them via the method of securitisation it is possible for the issuer to market illiquid assets to those interested in investing in them. Furthermore, this process also makes it possible for issuers to remove unsteady assets from their holdings thereby removing the threat that credit risk imposes.

The underlying assets that constitute such sets can range from automobile loans and student loans to credit card receivables and home equity loans among other expected cash flows. Ultimately issuers of asset-backed securities have the freedom to be as creative as they would like. Take for instance some ABSs which have been created keeping in mind the cash flows drawn from solar photovoltaics, movies revenues, toll roads, aircraft landing slots and royalty payments. Basically, almost any vehicle or situation capable of producing cash can undergo asset-backed securitisation.

The reason as to why investors may gravitate towards ABSs is owed to the fact that they provide them with an opportunity to benefit from a source of revenue. By investing in an ABS, it is possible for investors to be exposed to a wide range of assets that generate an income. On occasion, some of these income-generating assets may not otherwise be available to or accessible via alternative investments.

Understanding the Mechanisms that Govern Asset-Backed Securities

In order to understand the way an asset-backed security operates, consider company ABC that is responsible for making automobile loans. Now, if an individual wants to borrow money such that they can purchase a car, company ABC can provide them with the cash they need. The individual would then be required to repay the money that they’ve borrowed along with a specified amount of interest. Now, in the process of providing people with tons of loans, company ABC may find that they have run out of cash. In order to generate cash such that they can continue to operate, company ABC can choose to package its existing loans and sell them to an investment firm. The cash that is now funnelled into company ABC can allow them to continue to provide more loans.

The investment firm involved in the process can sift through and organise the loans that they have purchased into different groups that are called tranches. Each tranche houses loans that exhibit similar traits pertaining to their interest rate, the expected delinquency rate, and the maturity applicable. Following the creation of these tranches, the investment firm in question can begin to issue securities keeping in mind each tranche it has created. Much like bonds, each asset-backed security is tethered to a rating that indicates the extent of its riskiness i.e., the possibility of the underlying loans being defaulted.

Individual investors are then entitled to purchase said securities and are then the recipients of cash flows that are generated via the underlying set of auto loans. The cash flows received by investors incur an administrative fee that the investment firm allocates for itself.

Special Considerations Pertaining to Asset-Backed Securities

Almost any given asset-backed security is likely to have three tranches i.e., classes A, B and C of which A is the senior tranche. It also happens to almost always be the biggest tranche and is designed to have an investment-grade rating that is meant to draw in investors.

Tranche B has a credit quality that is lower and therefore brings in a higher yield than tranche A. The credit rating assigned to tranche C falls below that of tranche B and may feature a poor credit quality owing to which it may not be available for sale to investors. In such scenarios, the issuer would hold onto tranche C and absorb the losses it incurs.

Types of Asset-Backed Securities

From a theoretical point of view, an ABS can be generated from almost anything that is capable of drawing in a revenue stream. That being said, the more popular forms of ABSs include auto loan ABSs, collateralised debt obligations, credit card receivables ABSs, home equity ABSs and student loan ABSs.

Wrapping Up

Prior to investing in an asset-backed security, you must always take into account your threshold for risk, the timeframe you are willing to devote to this investment and whether your financial goals are aligned with asset-backed securities or not.