Asset-backed securities (ABS) are pools of loans that are bundled together and sold to investors as securities – this process is known as “securitization.” Types of loans that are typically securitized include residential mortgage loans, credit card debt, auto loans (including loans for recreational vehicles), home equity loans, student loans, and boat loans.
Asset-Backed Securities: How Do They Work?
When a consumer takes out a loan, their debt becomes an asset on the lender’s balance sheet. The lender can then sell these assets to a trust or “special purpose vehicle,” which pools them into an asset-backed security that can be sold in the public market. The interest and principal payments made by consumers are passed on to the investors who own the asset-backed securities. Individual securities are typically bundled into “tranches” or groups of loans with similar ranges of maturities and default risk.
Benefits of Asset-Backed Securities
The benefit to the issuer of asset-backed securities is that it removes these items from their balance sheet, providing them with a new source of funds and greater flexibility to pursue new business opportunities. The benefit to the buyer – typically institutional investors – is that they can earn additional yield compared to government bonds and enhance the diversification of their portfolios.
Risks of Asset-Backed Securities
Although some investors have been successful with asset-backed securities, some have historically turned into poor investments. The collapse of asset-backed securities backed by subprime mortgages was what triggered the Great Recession that began in late 2007.
Only financially sophisticated and wealthy investors should purchase individual asset-backed securities directly. Assessing the underlying loans requires extensive research, and obtaining the necessary data is not always easy.
Asset-backed securities carry some prepayment risk, which is the risk that investors may experience reduced cash flows due to borrowers paying off their loans early, particularly in a low-yield environment where borrowers can refinance their existing loans at lower rates.
The mixed history of asset-backed securities indicates a need for caution, even when purchasing securities rated AAA or AA. In the past, the credit ratings associated with asset-backed securities provided by Moody’s and other rating agencies were not always reliable. It is also wise to purchase asset-backed exchange-traded funds from large, reputable issuers such as BlackRock, Fidelity, and Vanguard, and to invest in products with investment-grade ratings.
Source: https://www.thebalancemoney.com/what-are-asset-backed-securities-abs-416909
Leave a Reply