What are Asset-backed Securities?

An asset-backed security (ABS) refers to a security that is collateralized by a pool of financial assets. This asset-backed security derives its income payment and values from the pool of assets and serves as its collateral. An ABS derives collateralization from royalties, credit card debts, receivables, loans and leases. The specified pool of assets that collateralize an ABS cannot be traded individually since it is a pool.

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How Does an Asset-backed Security Work?

The cash generated through ABS provides more funding for issuers which they package as loans. Companies that issue asset-backed securities package these securities as a pool of loans sold as securities. The process of packaging pool of loans issued and sold as securities is called securitization. ABS are packaged as a pool because they cannot be sold separately. Investors of asset-backed securities are also exposed to an avenue to invest in a diversified and revenue-generating assets. The poll of assets that back up these securities include equity loans, credit card debts, student loans, receivables, loans, among others. There are multiple benefits of Asset-Backed (AB) Securities. Mainly, they provide a way for lenders to obtain funds to lend. These securities provide traders an investment opportunity in a wide-ranging group of income-generating assets. In comparison to other income generating securities, for example Treasuries and corporate bonds, the market for asset-backed Securities market is less developed and can be more volatile. It is important because cash flows back the AB security, rather than physical assets. For example student loans, home capital loans, car loans, and credit card receivables are commonly securities into ABSs. 

Example of Asset-Backed Security 

This illustration is important for a clearer understanding of how asset-backed security work; Company XYZ issues automobile loans to borrowers, this company has issued loans to the point that there is no more cash left to facilitate other loans. Once Company XYZ sees that it has no more cash for loans, it packages all the loans it has currently issued (including the expected interest payment) and sells to an investment bank who pays Company XYZ cash with which it makes more loans. The Investment bank that has purchased the loans categorize them in line with their interest rates, maturity dates and delinquency rate. The different groups created are called tranches. The investment bank will proceed by issuing securities similar to what the tranches represents, these securities are sold to investors who receive income payments from the underlying assets such as the auto loan.

Typical Tranches

There are three tranches which are peculiar to asset-backed securities, these tranches are called;

• Class A tranche: This is the senior tranche and the most attractive to individual investors. It is the largest of all.
• Class B tranche: This is lower in credit quality when compared to the Class A tranche but has a higher yield.
• Class C tranche: this class of tranches cannot be issued or sold to investors because it has the lowest credit rating as well as a poor credit quality. Issuers accrue and absorb the losses associated with the Class C tranche.