What are Asset-Backed Securities (ABS)?

//What are Asset-Backed Securities (ABS)?
What are Asset-Backed Securities (ABS)? 2017-09-30T06:19:34+00:00

Definition: Asset-backed securities (ABS) are securities, usually bonds, which are collateralized by financial assets, such as home equity lines, credit card receivables, and auto loans.

What Does Asset Backed Securities Mean?

What is the definition of asset-backed securities? Financial institutions, such as banks, auto finance companies, and credit card providers, are using auto loans, student loans, home-equity loans, leases, credit card debt or royalties as collateral for bonds. The repayment of these loans is used to pay the interest to the investors who buy the bonds, whereas the loans are converted into marketable securities through securitization.

The main benefit of asset-backed securities is that they offer investors the opportunity to invest in a diversified portfolio of income-generating assets with a yield premium compared to assets with the same credit rating. Furthermore, they offer lenders the opportunity to issue additional loans, once the illiquid assets are converted into cash. On the downside, ABSs incur a prepayment risk, which is the risk that borrowers may pay off their debts earlier, thereby lowering the cash flows generated.

Let’s look at an example.

Example

Company A is an auto finance company that offers car loans to consumers seeking to buy a new car. The company gives cash to the borrower, and the borrower agrees to repay the loan amount with interest.

The manager came up with a new way to increase the number of loans that the company gives out every month. He has read several articles on asset backed securities, and he decided that the company should capitalize on the opportunity to issue additional debts.

Company A sells its debt to an investment firm and receives the corresponding amount of cash, which allows the company to issue new debt and transfer them to the investment firm’s balance sheet. In the majority, the new automobile loans have the same maturity and inherent risk; therefore, the investment firm can issue a bond that forwards the proceeds of the auto loans to its investors.

The investment firm can trade its ABS, i.e. the bonds used as collateral for the vehicle loans, on various exchanges provided that they meet the securitization requirements.

Summary Definition

Define Asset-Backed Security: ABS means a financial instrument that is guaranteed against default with an asset.