Asset-backed Security (ABS)

Asset-backed Security (ABS)

An asset-backed security (ABS) is a security in which the income payments and thus the value are derived from and collateralized (or “backed”) by a specific pool of underlying assets. These are financial instruments that are created by pooling together various types of debt assets, such as mortgages, auto loans, credit card debt, or student loans, and then securitizing them into tradable securities. The structure and features of ABS can vary widely depending on the type of underlying assets, the credit quality of the borrowers, and the specific terms of the securitization.

ABS can take various forms, such as mortgage-backed securities (MBS), collateralized debt obligations (CDOs), and asset-backed commercial paper (ABCP).  It is a type of financial investment that is backed up by an underlying pool of assets, typically those that generate cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, and it pays a fixed rate of interest until maturity. Asset-backed securities can be a good alternative to corporate bonds or bond funds for income-seeking investors. The cash flows generated by these underlying assets are used to pay interest and principal to the investors who hold the ABS.

The pool of assets is typically a collection of small and illiquid assets that cannot be sold separately. Pooling the assets into financial instruments enables them to be sold to general investors, a process known as securitization, and diversifies the risk of investing in the underlying assets because each security represents a fraction of the total value of the diverse pool of underlying assets. Underlying asset pools can range from common payments from credit cards, auto loans, and mortgage loans to esoteric cash flows from aircraft leases, royalty payments, or movie revenue.

ABS are popular with investors because they offer higher yields than traditional bonds and have different risk profiles. They are also attractive to issuers, such as banks and other financial institutions, because they can free up capital for further lending by removing the underlying assets from their balance sheets. However, ABS also come with risks, such as prepayment and default risk, and their values can be highly sensitive to changes in interest rates, credit spreads, and economic conditions.

Asset-backed securities enable their issuers to raise funds for lending or other investment purposes. The underlying assets of an ABS are frequently illiquid and cannot be sold separately. So, by pooling assets and forming a financial instrument out of them (a process known as securitization), the issuer can make illiquid assets marketable to investors. It also allows them to remove riskier assets from their books, lowering their credit risk.