Asset Backed Securities(ABS) are fixed income instruments, which pools different type of loans and which are sold as securities. These are usually backed by credit card receivables, student loans, auto loans etc., other than mortgage backed.
ABS has evolved from Mortgage Backed Securities (MBS) which are backed by mortgage loans and ABS are created from the pooling of non-mortgage assets.
How it Works?
ABS pools all asset loans of similar tenure such as student loans, auto loans and credit card debt into a security, or securities, which will be sold to investors. Means when every month loan payments happen, the monthly loan payments are turned into securities through process called securitization, which will be passed on from the bank to the bond holders every month.
Features of ABS
1) ABS can be considered as secure investment as they are backed by collateral. Like any other debt instruments these are labeled with ratings depending on the their ability to pay interest and principal as scheduled.
2) ABS offers higher yield when compared to other bond instruments or corporate bond with comparable maturities.
3) Investing in ABS is type of diversification as they are backed by different types of loans such as credit card receivables to auto, boat and recreational vehicle loans.
4) Maturity of loans are relatively shorter when compared to other bonds. So, if there is any fluctuation in interest rates ABS are less affected.
5) However, ABS carry pre-payment risk. Wherein, the investors may see reduced cash flows when the borrowers of asset loans pay their loans early. One needs to keep in mind that most of the loans are sensitive to interest rate changes. And loans which are backed in ABS are have more chances of default as there is no collateral used.
ABS and MBS are very popular investment instruments abroad. In India, they are still in primary stage.