What Are Asset-Backed Securities and How Do They Work

In the vast landscape of financial instruments, Asset-Backed Securities (ABS) stand out as a unique and invaluable investment. Before we delve into the intricate workings of ABS, let's pave the way with a brief exploration of the broader financial market. ABS are financial instruments backed by a pool of assets such as loans, mortgages, or invoice receivables.

Advantages of Asset-Backed Securities (ABS):

ABS offer attractive advantages to investors, making them a prominent option in financial markets.

Diversification: ABS empower investors to strategically diversify their portfolios, a crucial approach to reducing risk and increasing total return. Imagine an investor diversifying away from their traditional investments into a different pool of assets, thus creating a flexible and balanced portfolio.

Liquidity: The fact that ABS can be traded on exchanges makes them relatively liquid investments. This liquidity provides investors with the flexibility to easily buy and sell ABS, responding to market conditions or individual financial strategies.

Yield: The appeal of ABS lies in the potential for higher returns compared to other investments such as bonds or certificates of deposit (CDs). This higher return is a result of the cash flow generated by the underlying asset pool.

How Asset-Backed Securities (ABS) Work:

Understanding the intricate process of creating and securitizing a pool of assets as ABS is paramount for investors.

The process begins when a bank or issuer, known as the originator, sells a pool of underlying assets to a Special Purpose Vehicle (SPV).
The SPV, operating as a separate legal entity, issues ABS to investors.
Proceeds from the issuance of the ABS are used by the SPV to pay the originator for the underlying assets.
The SPV effectively manages the pool of underlying assets and collects the cash flow from these assets.
This cash flow is then used by the SPV to pay ABS investors.

Asset-Backed Securities (ABS) Features:

ABS are structured with specific features tailored to various investor needs.

Tranches: ABS are typically divided into tranches, each representing different classes of securities with different risk profiles. For example, a top tranche may carry a higher credit rating and a lower yield compared to a bottom tranche.

Waterfall: The waterfall structure determines how cash flow from the underlying assets is distributed to ABS investors, with priority generally given to the top tranches and the remaining cash flow directed to the bottom tranches.

Credit Enhancement: Mechanisms such as overcollateralization, subordination, and guarantees are used to mitigate the risk of ABS for investors.

Complexity of Asset-Backed Securities (ABS):

While ABS is a complex investment product, this blog aims to simplify the workings of ABS so that investors can make informed decisions.

Conclusion:

In conclusion, ABS is emerging as a valuable financial instrument that benefits both investors and originators. Investors gain the potential for higher returns and portfolio diversification, while originators have the opportunity to raise capital and improve liquidity. Understanding the details of ABS equips you to make informed investment decisions in the dynamic finance landscape. Whether you are an experienced investor or exploring investment options for the first time, the world of ABS offers a realm of possibilities worth exploring further. Happy investing!

Author
Sercan KURUL
Product Owner