What are asset-backed securities (ABS)?
Asset-backed securities, or securitised assets, are a type of bond investment. However, instead of repayments coming from the revenues of a company or government, as with other bonds, the repayments come from a pool of assets. These can include:
The originator of the investments might be a government agency (for example, the Federal Home Loan Mortgage Association, commonly known as Freddie Mac) or a bank. The originator deals directly with the borrowers to arrange the loans/credit checks, but other investors provide the money for the loans. This pool of loans is ‘securitised', or turned into securities – hence the alternative name for asset-backed securities is ‘securitised assets'.
How ABS work in practice
Mechanism – The originator works directly with consumers to create new loans, carry out credit screening and service the loans. This could be a high street bank that arranges mortgages for families, for example. They will have certain criteria for lending, which are based on credit scores, household income and expense, and loan-to-value ratios. This bank has limited capital to allow it to do new business, so to enable it to keep offering mortgages it will sell them to other investors through the securitisation process. In this way, other investors provide the capital for these loans (Figure 1).
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Figure 1: ABS mechanism in practice
A group of these loans are pooled together and sold to a company called a special purpose vehicle (SPV). The company exists purely to take the loans and allow the securitisation to take place, and has no other business apart from this. This company issues a range of different bonds (the asset-backed securities), with the buyers of the ABS providing the funds for the SPV to buy the loans.
Key terms: originator, securitisation
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Prioritising payment of coupons and repayment of principal
The bonds issued are repaid from the pool of loans: the most senior (ie the highest rated) bonds are paid first and then subsequent tranches down the credit scale (Figure 2). The repayments cover both interest and the repayment of principal. If losses occur, these affect the most junior securities first (known as ‘equity', but not in the traditional corporate sense. It is similar to how equity holders in a company are the last to be paid in case of liquidation; here they are first affected by any losses). These junior tranches absorb losses and protect the senior securities – a process called ‘credit enhancement'. The junior bonds are compensated for the higher risk with a higher yield.
Figure 2: Up and down the credit scale
Different investors are attracted to different seniority ABS. The senior bonds are generally purchased by pension funds, banks, insurance companies and individual investors. The junior tranches are attractive to hedge funds and other specialist managers.
Key terms: tranche, junior/senior bonds, credit-enhancement
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What are the different types of ABS in US markets?
The American ABS market is enormous. In fact, it is the second largest bond market in the world after US Treasuries. Within ABS there are a number of different types of bond:
Closing thoughts
Asset-backed securities offer a unique way for investors to access diversified pools of consumer and corporate credit, with varying levels of risk and return. By understanding the structure and mechanics of ABS, investors can better appreciate how these instruments fit into the broader fixed income landscape.
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Important information:
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