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Asset-Backed Securities: Definition and How to Invest

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Here's everything you need to know about asset-backed securities.

Asset-backed securities, or ABS, are securities backed by a pool of fundamental assets. Typically, the pool of assets is a small group of loans or debt obligations that cannot be sold to individual investors. Packaging these assets as a single financial instrument allows them to be sold to investors. Since the underlying assets are diversified, there is less risk exposure for those who invest. Read on to learn more about ABS and if they are a suitable investment for your asset mix.

Asset-Backed Securities Explained

Similar to mortgage-backed securities, asset-backed securities are securities backed by a pool of assets that, in turn, create cash flow. However, this pool of assets isn’t backed by mortgages. Some of the assets that back these securities include home equity loans, student loans, auto loans and credit card receivables. Typically, lenders or financial firms cannot sell these pools on their own.

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.

How Asset-Backed Securities Work

Here's everything you need to know about asset-backed securities.

For example, let’s say Company ABC lends borrowers home equity loans. If a borrower would like to take out a home equity loan, a lender will give that borrower cash in exchange for repayment terms and conditions which include interest payments. If Company ABC is making a lot of money on home equity loans, they may have the ability to lend to more borrowers if the current loans were packaged together.

Therefore, they could decide to bundle the home equity loans and sell them to an investment institution and use the proceeds to lend to even more borrowers. Once the transaction is complete, the financial institution will place these securities into a variety of groups or otherwise known as tranches. Each tranche has a collection of assets or loans with similar characteristics like maturity, interest rates or delinquency rates.

Once the investment institution has grouped the loans in to a tranche, they will issue asset-backed securities. You could compare these securities to a typical bond based on the tranche it creates.

How to Invest in Asset-Backed Securities

Investment firms usually divide ABS into three different tranches: class A, class B and class C. Typically, tranche A has the largest pool of loans as well as a rating that investors may prefer. Tranche B offers a lower credit quality and therefore has a higher yield than tranche A. Essentially, the investor is taking on more risk which may yield a greater return.

Lastly, tranche C has the lowest credit quality, which often cannot be sold to investors and must absorb the losses from the other tranches. Understanding what each tranche offers will help you select the most suitable ABS for your portfolio.

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.

Pros and Cons

Here's everything you need to know about asset-backed securities.

Many investors think of ABS as attractive investment selections since they’re known as secure investments. Similar to other securities, they are assigned a rating based on their ability to receive timely payments of the interest and principal amount. Since collateral and protections back these securities, it’s more likely that debt obligations are fulfilled. From a credit standpoint, ABS are one of the most stable investment selections.

Additionally, because ABS underlying assets secure these securities, they offer protection against potential risk. Investors often prefer them over corporate bonds because no matter how highly rated the bond is, a specific event could cause the rating agency to downgrade their ratings. These events may include a merger acquisition, restructuring or reorganization of the firm.

Another benefit of investing in an ABS is the diversification it offers. Because ABS represent many sectors of business activity, it allows investors to diversify their fixed-income portfolio.

However, investors face a few risks when investing in ABS. In some cases, investors run the risk of prepayment. This means that when a borrower accelerates their payment schedule, it may reduce the cash flow investors see. This tends to happen in declining interest rate environments.

Another risk investors may encounter is if the borrowers default on their loan payments. When borrowers can no longer afford to make payments on their loan, funds may not flow into the security as expected. Thus, potentially not providing the return that the investor anticipated.

The Bottom Line

Investing in asset-backed securities can be a good alternative to corporate bond investments. It may also be a great way to diversify your portfolio so that you can try to minimize your losses. It may be smart to review each ABS before taking the plunge and investing so you can find the one that’s right for your financial situation.

Tips for Investors
  • Navigating the ABS landscape can be challenging. It may help to talk with an expert who can guide you through the system. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • There are many ways to invest outside of securities. If you’re looking to minimize your risk, you can explore high-interest savings accounts, CDs or regular savings accounts. Your earnings might be much less compared to securities, but you also get to keep all your money.

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