Asset-Backed Securities (ABS)
A security whose income payments and hence values are derived from and backed by a specified pool of underlying assets are known as Asset-Backed Securities (ABS). An ABS is an investment security consisting of a bond or note that is collateralized by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables. ABS is a pool of loans that are packed and sold to investors as securities through a process known as securitization. This pool is a group of illiquid and small assets that cannot be sold individually.
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How do they work?
When an investor takes a loan, the debt becomes an asset for the lender. The lender in turn sells these assets to a trust or SPV which turns these assets into ABS which can be sold in the public market. The Interest and principal payments pass through to the investors who own ABS.
In simple terms it follows a 5-step process:
- Lenders make loans to dealers and consumers.
- Lender bundles a pool of these loans into securities.
- Lender issues these securities on the debt market.
- Securities are purchased by investors.
- The lender uses proceeds to extend new loans.
Pros and Cons:
- ABS secures security; they offer protection against potential risk.
- They are always preferred over corporate bonds.
- Investing in ABS provides diversification.
- Prepayment risk arises in case the investors repay early.
- Investors face risks if the borrower defaults in his payment.
Company B gives loans to consumers who are willing to purchase vehicles. The company gives cash to the borrower and he agrees to repay the loan with interest. The manager came up with new ideas to increase the number of loans that the company sanctions every month. He researched asset-backed securities, and he decided that the company should capitalize on the opportunity to issue additional debts.
Company B sells its debt to an investment firm and receives the corresponding amount of cash through which the company issues new debt and transfer them to the investment firm’s balance sheet. Majorly, the new automobile loans have the same maturity and inherent risk; therefore, the investment firm can issue a bond that forwards the proceeds of the auto loans to its investors. The investment firm trades its ABS, i.e., the bonds used as collateral for the vehicle loans, on various exchanges after fulfilling the requirements.
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ABS guarantees against default with an asset. Investments in ABS are a good alternative to corporate bond investments. An ABS has 3 tranches classes A, B, and C. These tranches help in diversifying the portfolio, thus minimizing losses.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).