Asset-Backed Security (ABS): What It Is, How Different Types Work (2022)

What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables.It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Key Takeaways

  • Asset-backed securities (ABSs) are financial securities backed by income-generating assets such as credit card receivables, home equity loans, student loans, and auto loans.
  • ABSs are created when a company sells its loans or other debts to an issuer, a financial institution that then packages them into a portfolio to sell to investors.
  • Pooling assets into an ABS is a process called securitization.
  • ABSs appeal to income-oriented investors, as they pay a steady stream of interest, like bonds.
  • Mortgage-backed securities and collateralized debt obligations can be considered types of ABS.

Understanding Asset-Backed Securities (ABSs)

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can't be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans,or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren't available in any other investment.

How an Asset-Backed Security Works

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use tomake more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

Special Considerations

An ABS will usually have three tranches:class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by aspecial purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

(Video) Asset-Backed Security (ABS) 11380

  • Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
  • Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
  • Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt.
  • Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.
  • Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn't qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

A mortgage-backed security (MBS) is sometimes considered a type of ABS but is more often classified as a separate variety of investment, especially in the U.S. Both operate in essentially the same way; the difference lies in the underlying assets in the portfolio. Mortgage-backed securities are formed by pooling together mortgages exclusively, while ABSs consist of any other type of loan or debt instrument (including, rather confusingly, home equity loans).MBSs actually predate ABSs.

Auto Loan ABS

Car financing is another large category of ABS. The cash flows of an auto loan ABS include monthly interest payments, principal payments, and prepayments (though the latter is rarer for an auto loan ABS is much lower when compared to a home equity loan ABS). This is another amortizing loan.

Credit Card Receivables ABS

Credit card receivables—the amount due on credit card balances—are a type of non-amortizing asset ABS: They go to a revolving line of credit, rather than towards the same set sum. So they don't have fixed payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually alock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After thelock-up period, the principal payment is passed on to ABS investors.

Student Loan ABS

ABSs can be collateralized by either government student loans, guaranteed by the U.S. Dept. of Education, or private student loans. The former have had a better repayment record, and a lower risk of default.

(Video) What are Asset Backed Securities? | Made in Germany

An ABS will usually have three tranches:class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

What Is an Example of an Asset-Backed Security?

Acollateralized debt obligation (CDO) is an example of an asset-based security (ABS). It is like a loan or bond, one backed by a portfolio of debt instruments—bank loans, mortgages, credit card receivables, aircraft leases, smaller bonds, and sometimes even other ABSs or CDOs. This portfolio acts as collateral for the interest generated by the CDO, which is reaped by the institutional investors who purchase it.

What Is Asset Backing?

Asset backing refers to thetotalvalueof a company'sshares, inrelationtoitsassets. Specifically, it refers to thetotalvalueof all theassetsthat a company has,dividedby thenumberof outstandingsharesthat the company hasissued.

In terms of investments, asset backing refers to a security whose value derives from a single asset or a pool of assets; these holdings act as collateral for the security—"backing" it, in effect.

What Does ABS Stand for in Accounting?

In the business world, ABS stands for "accounting and billing system."

(Video) 2017 Level I CFA Fixed Income: Asset-Backed Securities - Summary

What Is the Difference Between MBS and ABS?

An asset-based security (ABS) is similar toa mortgage-backed security (MBS). Both are securities that, like bonds, pay a fixed rate of interest derived from an underlying pool of income-generating assets—usually debts or loans. The main difference is that an MBS, as its name implies, consists of a package of mortgages (real estate loans). In contrast, an ABS is usually backed by other sorts of financing—student loans, auto loans, or credit card debt.

Some financial sources do use ABS as a generic term, encompassing any sort of securitized investment based on underlying asset pools—in which case, an MBS is a kind of ABS. Others consider ABSs and MBSs to be separate investment vehicles.

How Does Asset Securitization Work?

Asset securitization begins when a lender (or any company with loans) or a firm with income-producing assets earmarks a bunch of these assets and then arranges to sell the lot to an investment bank or other financial institution. This institution often pools these assets with comparable ones from other sellers, then establishes a special-purpose vehicle(SPV)—an entity set up specifically to acquire the assets, package them, and issue them as a single security.

The issuer then sells these securities to investors, usually institutional investors (hedge funds, mutual funds, pension plans, etc.). The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the portfolio of assets.

(Video) Mortgage-Backed Securities (MBS) Explained in One Minute: Did We Learn Our Lesson?

Sometimes the issuer divides the original asset portfolio into slices, called tranches. Each tranche is sold separately and bears a different degree of risk, indicated by a different credit rating.

FAQs

What is ABS security type? ›

Asset-backed securities (ABSs) are financial securities backed by income-generating assets such as credit card receivables, home equity loans, student loans, and auto loans.

What is an example of an asset-backed security? ›

Asset-backed securities (ABS) finance pools of familiar asset types, such as auto loans, aircraft leases, credit card receivables, mortgages, and business loans. In one way or another, these asset types represent contractual obligations to pay.

How do asset-backed securities transactions work? ›

Securitization involves pooling debt obligations, such as loans or receivables, and creating securities backed by the pool of debt obligations called asset-backed securities (ABS). The cash flows of the debt obligations are used to make interest payments and principal repayments to the holders of the ABS.

What is the difference between covered bonds and asset-backed securities ABS? ›

Unlike asset-backed securities created in securitization, the covered bonds continue as obligations of the issuer; in essence, the investor has recourse against the issuer and the collateral, sometimes known as "dual recourse".

How many ABS types are there? ›

ABS types. There are three basic types of anti-lock braking systems: four-channel/four-sensor, three-channel/three-sensor and one-channel/one-sensor.

What is ABS risk? ›

ABS carry some prepayment risk, which is the chance that investors will experience reduced cash flows caused by borrowers paying off their loans early, particularly in a low-yield environment when borrowers can refinance existing loans at lower rates.

What are the 4 types of security? ›

What are the Types of Security? There are four main types of security: debt securities, equity securities, derivative securities, and hybrid securities, which are a combination of debt and equity. Let's first define security.

What are three types of assets in security? ›

Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments.

What types of assets are security? ›

Securities are fungible and tradable financial instruments used to raise capital in public and private markets. There are primarily three types of securities: equity—which provides ownership rights to holders; debt—essentially loans repaid with periodic payments; and hybrids—which combine aspects of debt and equity.

What are 4 asset types that are common to securitizations? ›

Securitized products are valued based on the cash flows of the underlying assets. Mortgages (residential and commercial), credit card receivables, auto loans, student loans, etc. can each be pooled together to create securitizations.

What is asset-backed risk? ›

An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized (or "backed") by a specified pool of underlying assets.

How do I buy ABS security? ›

If you decide you want to invest in an ABS, you can purchase one at almost any brokerage firm. If you work with a financial advisor, they can assist you in selecting the most suitable ABS for your portfolio and cash flow needs.

Is ABS a covered bond? ›

ABS, meanwhile, are also backed by a pool of loans (or leases), but unlike covered bonds, the securities are issued by special purpose vehicles (SPV) with the underlying assets held off balance sheet.

Are ABS considered bonds? ›

Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans,¹ such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.

What is the difference between asset based loan and bond? ›

The primary difference between Bonds and Loan is that bonds are the debt instruments issued by the company for raising the funds which are highly tradable in the market, i.e., a person holding the bond can sell it in the market without waiting for its maturity, whereas, the loan is an agreement between the two parties ...

What are the two main types of ABS used? ›

There are two main types of modern ABS systems: three and four channel. Three channel systems control the braking pressure on both front wheels independently, but control the rear wheels together as a single unit.

What is the most common type of ABS? ›

Four-channel ABS - This is the most commonly used and the most effective form of the ABS, for the fact that it works only on the affected wheel out of all the four wheels in case of sudden braking. It has sensors employed on all four wheels of the car.

What are the 4 main stages of ABS operation? ›

These include : (i) pressure reduction phase, (ii) pressure maintenance phase, and (Hi) pressure increase phase. The input and return valves in each fluid circuit control these phases and provide the maximum braking force without exceeding the skid limit for the prevailing road conditions.

What are the 3 risk categories? ›

Here are the 3 basic categories of risk:
  • Business Risk. Business Risk is internal issues that arise in a business. ...
  • Strategic Risk. Strategic Risk is external influences that can impact your business negatively or positively. ...
  • Hazard Risk. Most people's perception of risk is on Hazard Risk.
4 May 2021

What is ABS and its importance? ›

ABS operates by preventing the wheels from locking up during braking, thereby maintaining tractive contact with the road surface and allowing the driver to maintain more control over the vehicle.

What are the 7 principles of security? ›

Security by Design: 7 Application Security Principles You Need to Know
  • Principle of Least Privilege. ...
  • Principle of Separation of Duties. ...
  • Principle of Defense in Depth. ...
  • Principle of Failing Securely. ...
  • Principle of Open Design. ...
  • Principle of Avoiding Security by Obscurity. ...
  • Principle of Minimizing Attack Surface Area.

What are the 5 basic principles of security? ›

The Principles of Security can be classified as follows:
  • Confidentiality: The degree of confidentiality determines the secrecy of the information. ...
  • Authentication: Authentication is the mechanism to identify the user or system or the entity. ...
  • Integrity: ...
  • Non-Repudiation: ...
  • Access control: ...
  • Availability:
5 Jun 2022

What are the 3 key principles of security? ›

What are the 3 Principles of Information Security? The basic tenets of information security are confidentiality, integrity and availability. Every element of the information security program must be designed to implement one or more of these principles. Together they are called the CIA Triad.

What are the three main assets? ›

Current Assets

Cash and cash equivalents: Treasury bills, certificates of deposit, and cash. Marketable securities: Debt securities or equity that is liquid. Accounts receivables: Money owed by customers to be paid in the short-term. Inventory: Goods available for sale or raw materials.

What are the two types of assets? ›

Tangible and Intangible Assets

Most of an organization's assets are usually classified as tangible assets. Examples of intangible assets are copyrights, patents, and trademarks. Examples of tangible assets are vehicles, buildings, and inventory.

What are the 4 types of assets? ›

Historically, there have been three primary asset classes, but today financial professionals generally agree that there are four broad classes of assets:
  • Equities (stocks)
  • Fixed-income and debt (bonds)
  • Money market and cash equivalents.
  • Real estate and tangible assets.
4 Mar 2021

What are the 7 types of assets? ›

These six types of assets are:
  • Current assets. Current assets are ones an owner can convert into cash or cash equivalents within a year through sale or account payments. ...
  • Fixed assets. ...
  • Tangible assets. ...
  • Intangible assets. ...
  • Operating assets. ...
  • Non-operating assets.

Who plays a big role in asset securitization? ›

The exhibit highlights the key roles in the securitization process: issuer, underwriter, rating agency, servicer, and trustee. 2 The issuer (sometimes referred to as sponsor or originator) brings together the collateral assets for the asset-backed security.

What are the benefits of asset securitization? ›

The primary benefit of securitization is to reduce funding costs. Through securitization, a company that is rated BB but maintains assets that are very high in quality (AAA or AA) can borrow at significantly lower rates, using the high quality assets as collateral, as opposed to issuing unsecured debt.

How many stages of securitization are there? ›

There are four steps in a securitisation: (i) SPV is created to hold title to assets underlying securities; (ii) the originator or holder of assets sells the assets (existing or future) to the SPV; (iii) the SPV, with the help of an investment banker, issues securities which are distributed to investors; and (iv) the ...

What assets are risk-free? ›

A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them.

What is asset backing value? ›

asset backing in Finance topic

From Longman Business Dictionary ˈasset ˌbacking (also asset cover) the total value of all the assets that a company has, divided by the number of shares that the company has issuedSYNASSET VALUE PER SHARE → backing.

How much does an ABS computer cost? ›

The total cost of parts and labor to replace an ABS control module can be anywhere between $320 and $1,000 depending on the cost of the control module itself and how difficult it is to find. Despite the cost, you should replace your cars ABS control module if: The brakes lock up even when you are driving normally.

How large is the ABS market? ›

Trading (as of October) $1,697.9 million ADV, -11.7% Y/Y. Outstanding (as of 4Q21) $1,585.3 billion, +3% Y/Y (dataset under review)

Why do investors invest in asset backed securities? ›

ABS gives lenders more ways to obtain a cash flow while offering investors the opportunity to invest in a diversified asset mix that produces income. Some investors may use ABS as an alternative to investing in corporate debt.

Are asset-backed bonds safe? ›

Senior ABS sit at the top of the capital structure, which means they benefit from robust structural protection and credit enhancement. They are therefore well-protected from potential losses in the collateral pool by the tranches below them, which has been successfully demonstrated in extreme market conditions.

Are Asset-Backed Securities safe? ›

By purchasing asset-backed securities, investors can receive access to interest and principal payments of various assets without having to originate them. Since each security only contains a fraction of all the underlying assets, the risk of default and other credit risks are minimized.

Is ABS a safe material? ›

ABS plastic and safety

Fortunately, ABS plastic is non-toxic and safe to use in a variety of ways. The material doesn't break down over time or release harmful chemicals. ABS plastic is made to last and made to protect the parts that it covers without causing any health risks for the consumer.

What are 3 types of common bonds? ›

There are three main types of bonds:
  • Corporate bonds are debt securities issued by private and public corporations.
  • Investment-grade. ...
  • High-yield. ...
  • Municipal bonds, called “munis,” are debt securities issued by states, cities, counties and other government entities.
10 Nov 2022

What are the 2 most common types of bonds? ›

Two of the most common types of U.S. savings bonds are I-bonds and Series EE Savings Bonds. I-bonds are a favorite safe investment vehicle, known for “virtually no credit and default risk,” according to the Financial Industry Regulatory Authority.

What are the 5 types of bonds? ›

There are five main types of bonds: Treasury, savings, agency, municipal, and corporate. Each type of bond has its own sellers, purposes, buyers, and levels of risk vs. return. If you want to take advantage of bonds, you can also buy securities that are based on bonds, such as bond mutual funds.

What are the four types of asset backed loans? ›

Credit scores are still obtained, but they are not the ultimate and definitive deciding factor with asset-based lending. The four major ABL asset classes are accounts receivable, inventory, equipment and real estate.

What are the two types of asset-based loans? ›

Typically, the different types of asset-based loans include accounts receivable financing, inventory financing, equipment financing, or real estate financing Asset-based lending in this more specific sense is possible only in certain countries whose legal systems allow borrowers to pledge such assets to lenders as ...

Is ABS a private credit? ›

ABS and consumer lending example:

Private: ABS backed by private short-term consumer loans sourced from a non-bank lender.

Is ABS a legal requirement? ›

Yes, all modern cars have ABS brakes as standard. ABS became a legal requirement in all new passenger cars from 2004.

How do I fix my ABS light? ›

Firstly, you should check your brake fluid reservoir to ensure that the levels aren't too low, as the ABS warning light can be activated if the levels of brake fluid have dropped. If this is clearly an issue, you can top the brake fluid up yourself, which should cause the ABS light to go off.

How does a ABS pump work? ›

How does the Anti-Lock Braking System work? ABS works by releasing and then reapplying or 'pumping' the brakes to a motorcycle wheel or car wheels in heavy braking situations. Sensors on each wheel are used to detect 'locking' or when a wheel stops moving and starts to skid.

How do I prepare for a private debt interview? ›

What experience do you need before going into private debt?
  1. Strong financial modelling skills a must.
  2. Corporate or project finance credit analysis.
  3. Basic knowledge of fixed income is nice to have. Ie. understanding of the bond market, how interest rate and duration impact bond valuation, yield curve, etc.
16 Jan 2018

Are Asset Backed Securities safe? ›

By purchasing asset-backed securities, investors can receive access to interest and principal payments of various assets without having to originate them. Since each security only contains a fraction of all the underlying assets, the risk of default and other credit risks are minimized.

Is the ABS a government agency? ›

I. Introduction. 1. The Australian Bureau of Statistics (the ABS) is the central statistical authority for the Australian Government and, by legal arrangements, provider of statistical services to Australian State and Territory Governments.

What is ABS and why is it safer? ›

ABSs offer an important safety advantage by stopping your vehicle's wheels from locking during emergency braking situations. An ABS does not necessarily shorten your stopping distance, but does allow you to keep steering control and drive your vehicle more effectively.

Can you drive without ABS? ›

In the winter, braking on any slippery surface will be as if the vehicle isn't equipped with ABS at all: Locked wheels, no steering, and decreased control. But, the brakes still have all the functionality they were equipped with from the factory, just no electronic ability to help the driver in a bad situation.

Who invented ABS? ›

Mercedes-Benz and the invention of the anti-lock braking system: ABS, ready for production in 1978.

Where is the ABS fuse located? ›

The fuse box for the ABS is located in the engine compartment on the passenger's side. To open it, push the tab as shown. 253 to 256, or the diagram on the fuse box lid, which fuse or fuses control that component. Check those fuses first, but check all the fuses before deciding that a blown fuse is not the cause.

How much does it cost to fix ABS light? ›

The total cost of parts and labor to replace an ABS control module can be anywhere between $320 and $1,000 depending on the cost of the control module itself and how difficult it is to find.

Can you reset the ABS light? ›

Step One: Disconnect the positive cable from your car battery. Then, hold down the brake pedal to drain the vehicle's electrical system. This will result in a reset of the car's central computer. Plug the cable back in to restore power.

How does ABS work simple? ›

In an anti-lock braking system, your car's wheel speed is monitored and if wheel lock is detected, a sensor sends a message to a controller that releases and applies the brake up to 20 times per second, preventing a lock up and helping you maintain control of your vehicle.

What causes ABS to activate? ›

A weak signal from a sensor is interpreted as a locked wheel, which triggers the computer to activate the ABS system and release brake pressure in an attempt to unlock the wheel.

Videos

1. What are Asset-backed securities (ABS)
(SAMT AG Switzerland)
2. Introduction to Asset Backed Securities
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3. CFA Level I - Fixed Income - Asset Backed Security | Part I(of 6)
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4. MaxTen | The characteristics of European asset-backed securities
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5. Asset Backed securities | Account receivable |Account payable
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6. Securitization and Mortgage Backed Securities
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