Asset-Backed Security (ABS)

An asset-backed security (ABS) is a financial instrument that is backed by a pool of assets, typically loans, leases, credit card debt, or receivables. These assets are bundled together and sold to investors in the form of securities. The cash flows generated by the underlying assets are used to pay interest and principal to the investors. ABS are commonly used to securitise various types of debt, providing liquidity and diversification for investors.

Why are asset-backed securities important?

Asset-backed securities play a crucial role in the financial markets for several reasons:

• Liquidity: ABS provide liquidity to lenders by allowing them to convert illiquid assets into tradable securities.
• Risk management: By pooling assets, ABS help distribute risk among multiple investors.
• Investment opportunities: ABS offer investors access to a diversified portfolio of assets, potentially providing higher returns than traditional fixed-income securities.
• Funding: Issuers use ABS to raise funds, which can be used for further lending or other business activities.

The asset-backed security process

Steps involved in creating an ABS

1. Asset pooling: The issuer pools together a collection of similar assets, such as loans or receivables.
2. Special purpose vehicle (SPV): The pooled assets are transferred to an SPV, which isolates them from the issuer’s balance sheet.
3. Securitisation: The SPV issues securities backed by the pooled assets, which are sold to investors.
4. Cash flow distribution: The cash flows generated by the underlying assets are used to pay interest and principal to the ABS investors.

Types of assets commonly securitised

• Auto loans: Loans used to finance the purchase of vehicles.
• Credit card receivables: Outstanding balances on credit cards.
• Student loans: Loans taken out by students to finance their education.
• Residential mortgages: Loans secured by residential properties.
• Commercial loans: Loans used for business purposes.

Types of asset-backed securities

Mortgage-backed securities (MBS)

MBS are a type of ABS that are specifically backed by a pool of mortgages. There are two main types of MBS:

• Residential mortgage-backed securities (RMBS): Backed by residential mortgages.
• Commercial mortgage-backed securities (CMBS): Backed by commercial real estate loans.

Collateralised debt obligations (CDOs)

CDOs are complex ABS that are backed by a diversified pool of debt instruments, such as bonds, loans, and other ABS. They are structured into different tranches, each with varying levels of risk and return.

Credit card receivable ABS

These ABS are backed by outstanding credit card balances. The cash flows from monthly credit card payments are used to pay interest and principal to investors.

Risks associated with asset-backed securities

Credit risk

Credit risk refers to the possibility that the underlying assets will default, leading to a loss for investors. This risk is influenced by the credit quality of the pooled assets.

Prepayment risk

Prepayment risk arises when borrowers repay their loans earlier than expected, leading to reduced cash flows for ABS investors. This is particularly relevant for assets like mortgages and auto loans.

Interest rate risk

Interest rate risk is the risk that changes in interest rates will affect the value of ABS. Rising interest rates can reduce the value of fixed-income securities, including ABS.

Liquidity risk

Liquidity risk is the risk that ABS may be difficult to sell in the secondary market, particularly during periods of financial stress.

Example of an asset-backed security

Consider a bank in Australia that has a large portfolio of auto loans. To free up capital and manage risk, the bank decides to securitise these loans. The bank pools the auto loans and transfers them to a special purpose vehicle (SPV). The SPV then issues asset-backed securities to investors, backed by the cash flows from the auto loan payments. Investors receive regular interest payments and principal repayments from the auto loans, while the bank benefits from increased liquidity and reduced risk exposure.

Conclusion

Asset-backed securities are a vital component of the financial markets, providing liquidity, diversification, and investment opportunities. By understanding the process and risks associated with ABS, investors and issuers can make informed decisions and effectively manage their financial portfolios.

For more information on asset-backed securities and related investment strategies, you can visit the Australian Securities and Investments Commission’s MoneySmart website.