Business, Legal & Accounting Glossary
An asset-backed security (ABS) is a financial security collateralised by a pool of assets such as loans, leases, credit card debt, royalties or receivables.
An asset–backed security (ABS) is a security whose income payments and hence value are derived from and collateralised (or “backed“) by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually.
For investors, asset–backed securities are an alternative to investing in corporate debt.
Asset-backed securities (ABS) alongside mortgage-backed securities (MBS) are two of the most important types of asset classes within the fixed-income sector.
An Asset-Backed Security (ABS) is a securitized interest in a pool of assets. Conceptually, the structure is similar to a mortgage-backed security (MBS), so it is convenient to describe the structure according to its differences from MBS.
MBSs are backed by mortgages—fixed rate, floating rate, residential, commercial, single-family, multi-family, etc. ABSs are backed by non-mortgage assets. This includes auto loans, credit card receivables, home equity loans, student loans, etc. Due to government guarantees, MBSs typically entail no credit risk. ABSs generally lack such guarantees, so they entail credit risk. Due to diversification of the underlying assets, as well as credit enhancements, that risk tends to be modest. ABSs can be subject to prepayment risk, but this is slight compared to that of MBSs. Consumers are more likely to refinance a home than an auto in response to a drop in interest rates.
ABSs are appealing to issuers because the structure allows them to get assets off their balance sheets, freeing up capital for further receivables. Also, ABSs make it possible for issuers whose unsecured debt is below investment grade to sell investment-grade—even AAA-rated—debt.
To create an ABS, a corporation creates a special purpose vehicle to which it sells the assets. While it is common to speak of the corporation as the issuer of the ABS, legally, it is the trust or special purpose vehicle that is the issuer. It sells securities to investors. To protect investors from possible bankruptcy of the corporation, there are three legal safeguards:
These same safeguards allow the corporation to remove the assets from its balance sheet. The corporation generally continues to service the assets—collecting interest and principal payments, pursuing delinquencies, etc. It is paid out of asset cash flows for providing these ongoing services.
For investors, ABSs are an alternative to highly-rated corporate debt. They generally offer similar or superior liquidity. Because the underlying assets are diversified, they are less subject to credit surprises.
ABSs can be structured into different classes or tranches, much like collateralized mortgage obligations (CMOs). There may be senior or subordinated classes of debt, which have different credit ratings. Tranches may be structured with different average maturities. The choice of the structure depends upon investor demand as well as the nature of the underlying assets.
A bond is a financial instrument between two parties. The corporation or government entity issuing the bond is the bond issuer. The individual or investment firm purchasing the bond is the bondholder. Some bonds sell at par, or face value, and pay a fixed rate of interest until the bond matures or the issuer calls it in. Other bonds sell at a discount to par are redeemed at face value at maturity. The difference between the purchase price and face value is interest.
Accrued income is interest that a bond has already earned, but the bond issuer has not yet made payment. For example, assume you purchase a $10,000 bond at a 20 percent discount to par from your local school board, with a 10-year maturity. You paid $8,000 for the bond and it will earn $2,000 interest during a 10-year period. You will earn interest every year on the bond but not receive any money until you redeem it. This unpaid interest is accrued income until the bond issuer pays you. Technically, you earn income during one taxable period but receive it in a future taxable period.
To calculate accrued income on a bond purchased at par, multiply the bond amount by the interest rate to arrive at the amount of lifetime interest. Then divide this amount by the length of time that you have owned the bond. To calculate accrued income on a bond purchased at discount, subtract the purchase price from the face value to ascertain the amount of interest. Then complete the calculation the same as a face value purchase by dividing the amount of interest by the length of time you have owned the bond.
You might have to pay state or federal tax on accrued income, even though you have technically not received the funds. Some states tax on all assets, and a bond purchased last year has a greater value this year. If you plan to invest a significant amount of money in this type of financial instrument, consult with a tax attorney to find out which type of bonds are best for your situation.
To help you cite our definitions in your bibliography, here is the proper citation layout for the three major formatting styles, with all of the relevant information filled in.
Definitions for Asset-Backed Security are sourced/syndicated and enhanced from:
This glossary post was last updated: 4th August, 2021 | 6 Views.