- Below, we detail what asset-backed securities are, the main types available, and the risks they involve.
- This information is intended for asset managers seeking to use structured financial instruments to optimize their investment strategies.
- FlexFunds offers an asset securitization program to create asset-backed securities. For more information, feel free to contact our experts.
The fixed income market is not limited to conventional bullet bonds issued by companies or governments. In fact, it’s so large (USD 143 trillion globally, according to J.P. Morgan) that it includes dozens of types of debt instruments, such as asset-backed securities.
What are asset-backed securities?
Specifically, asset-backed securities (ABS) are financial debt instruments backed by a pool of underlying assets.
These underlying assets generally produce cash flow from receivables such as loans, leases, credit card balances, or accounts receivable.
How do they work?
They operate like a bond or promissory note that distributes income at a fixed rate over a set period until maturity.
ABS allow issuers to obtain cash that can be used for lending or other investments, since the underlying assets are typically illiquid and not individually tradable.
Thus, pooling these assets and creating a financial instrument through securitization enables the issuer to transform illiquid assets into marketable securities for investors.
This structure also helps issuers remove higher-risk assets from their balance sheets, helping mitigate credit risk.
According to the U.S. Securities and Exchange Commission (SEC), payments from the underlying loans are typically distributed first to holders of the lower-risk, lower-interest securities, and then to holders of the higher-risk tranches.
Types of ABS
While there are many types of ABS, they can be grouped into three main categories:
Mortgage-backed securities
First are mortgage-backed securities (MBS), which, as the name suggests, are backed by mortgages.
They may be residential mortgage-backed securities (RMBS), if backed by residential mortgages, or commercial mortgage-backed securities (CMBS), if backed by commercial real estate like office buildings, shopping centers, or industrial facilities.
General asset-backed securities
Next are general ABS, which resemble MBS but are backed by assets other than mortgages.
These include auto loans, student loans, consumer loans, and other forms of non-mortgage debt.
Their role is to transform illiquid assets into tradable financial products through a securitization processâsuch as the one developed by FlexFunds.
Collateralized debt obligations
Lastly, we have collateralized debt obligations (CDOs).
These are structured instruments backed by portfolios of debt, which may include loans, bonds, or other credit assets.
They are further subdivided into:
- Collateralized loan obligations (CLOs), typically backed by corporate loans.
- Collateralized bond obligations (CBOs), backed by bond portfolios.
Risks to consider
Although asset-backed securities have been around for decades and are highly regulated and monitored, asset managers should still keep in mind some key risks:
The need for due diligence
Purchasing ABS comes with the challenge of evaluating the credit risk of numerous underlying assets, requiring thorough investigation.
Lower returns due to early repayments
ABS are also exposed to prepayment risk, when borrowers choose to pay off their loans early. This can reduce the returns for security holders.
Default risk during economic downturns
During recessions, the underlying assets may go into default, spreading the default risk across multiple assets.
However, if these assets are of low quality, defaults may become widespread, affecting the value of the ABS.
The importance of securitization in ABS
As previously mentioned, asset-backed securities are created through an asset securitization process.
Through this procedureâlike the one carried out by FlexFundsâa basket of assets can be converted into bankable assets with their own ISIN/CUSIP codes.
FlexFunds’ cost-efficient solution is complemented by a full-service offering that includes:
- Listing on a stock exchange
- Fund accounting
- Back-office services
- Net Asset Value (NAV) calculation
- Corporate administration services
To learn more about FlexFunds’ ETPs and our asset securitization program, feel free to contact our team of specialists. Weâll be happy to assist you!
Sources:
- https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/etf-insights/the-power-of-active-fixed-income-etfs.pdf
- https://www.investopedia.com/terms/a/asset-backedsecurity.asp
- https://www.sec.gov/spotlight/dodd-frank/assetbackedsecurities.shtml
