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Asset Backed Securities (ABS)

Guide to Understanding Asset Backed Securities (ABS)

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Asset Backed Securities (ABS)

Asset Backed Securities Primer

An asset backed security, or “ABS”, is a financial instrument such as a securitized loan where the borrower has pledged collateral as part of the financing agreement.

The underlying assets that are pledged to serve as collateral generate the income (i.e. the cash flows) that’ll be used to pay the periodic interest payments, mandatory principal amortization, and repayment of the entire principal at maturity.

If the borrower defaults on its debt obligations – for instance, suppose the borrower missed an interest payment or the repayment of the original debt principal on the date of maturity – the lenders possess the right to seize the pledged assets to help recoup the loss of their initial investment.

The process of collateralization describes borrowers securing debt instruments by pledging collateral, in which lenders obtain a lien on (i.e. a “right to”) the pledged assets that enables them to seize the assets if the borrower defaults on their debt obligations.

Since the debt is asset-backed, the lender’s downside risk is more protected and there is less risk overall associated with the financing. As a result, the interest rates and terms associated with asset-backed debt tend to be more favorable to the borrower than for unsecured debt financing.

Secured vs. Unsecured Debt

Collateralized debt is considered a secured loan, so there is generally less exposure to default risk for the lenders involved. In effect, collateralized debt – by virtue of being secured by assets – is characterized by lower interest rates than that of unsecured loans.

Borrowers with sub-par credit ratings can also raise debt capital more easily by pledging collateral.

List of Asset Backed Securities (ABS) Collateral

Collateral for debt securities most often consists of highly-liquid assets, meaning that the assets can be liquidated and turned into cash rather easily without losing a significant percentage of their original value.

The most liquid current assets are cash itself, cash equivalents (e.g. marketable securities, commercial paper), inventory, and accounts receivable.

Some common examples of asset backed securities (ABS) include:

  • Home Equity Loans
  • Auto Loans
  • Credit Card Receivables
  • Real Estate Mortgages
  • Student Loans

Classes of Asset Backed Securities (ABS)

There are several different types of asset backed securities,  and some common types are summarized below:

  • Mortgage-Backed Securities (MBS) → A bond offering secured by a pool of residential or commercial mortgage loans.
      • Residential Mortgage-Backed Securities (RMBS) → Mortgage-backed debt securities in which the cash flows stem from residential mortgages.
      • Commercial Mortgage-Backed Securities (CMBS) → Mortgage-backed debt securities backed by loans in the commercial real estate market as opposed to the residential market, e.g. the loans related to commercial properties such as apartment complexes and office buildings.
  • Collateralized Loan Obligation (CLO) → Debt issuances securitized by a pool of assets comprised of corporate loans, which are often ascribed lower credit ratings and associated with M&A, namely loans funding leveraged buyouts (LBOs).
  • Collateralized Debt Obligation (CDO) → Complex debt securities backed by a pool of various assets including fixed income instruments, mortgage-backed securities (MBS), real estate loans, and corporate bonds.

Structured finance products, such as a collateralized debt obligation (CDO), are typically sold to institutional investors.

For these types of securities, each investor can pick the specific tranche upon which they wish to hold an ownership claim.

Each tranche is different in terms of priority, and its location relative to all other claims determines the terms associated with each tranche, i.e. senior tranches are less riskier than the junior tranches, but may carry a lower expected return on investment for the lender.

The structure in securitization is termed “subordination”, which refers to the establishment of a ranking system of various classes or tranches based on the priority of claims.

Asset Backed Securities Example – Collateralized Loan Obligation (CLO)

An example of an asset-backed security is a collateralized loan obligation (CLO), which is a financial security backed by a pool of corporate loans that most often carry low credit ratings.

The securitization process of CLOs involves bundling corporate loans with low-credit ratings under the rationale that diversification can mitigate the credit risk from any particular individual loan.

The CLOs will be composed of different tranches to appeal to investors with varying risk appetites, i.e. each distinct class receives differing yields based on the level of risk undertaken.

A special-purpose vehicle (SPV) will then be set up by a financial institution with the sole function of purchasing corporate loans from borrowers such as private equity firms and then packaging those assets into a single collateralized loan obligation (CLO).

Once such a process is complete, the CLO will be sold to institutional investors in pieces – i.e. the various tranches, each with different risk/return profiles.

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