Asset-Backed Security

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Definition: Asset-Backed Security


Asset-Backed Security

Quick Summary of Asset-Backed Security


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.




What is the dictionary definition of Asset-Backed Security?

Dictionary Definition


 

An assetbacked 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, assetbacked 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.


Full Definition of Asset-Backed Security


An Asset-Backed Security (ASB) is a bond or note whose collateral is the cash flows from a pool of financial obligations such as mortgages, car loans, or credit-card receivables.

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:

  • Transfer of assets from the corporation is a non-recourse, true sale.
  • Investors receive a perfected interest in the assets’ cash flows.
  • A non-consolidation legal opinion is obtained certifying that assets of the trust or special purpose vehicle cannot be consolidated with the corporation’s assets in the event of bankruptcy.

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.

Bonds

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

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.

Calculation

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.

Taxation

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.


Synonyms For Asset-Backed Security


asset-backed, ABS


Asset-Backed Security FAQ's


What Is An Asset-Backed Security?

An asset-backed security, or trust preferred stock, is a new class of bonds.

They are listed and traded on major stock exchanges as preferred stocks. Each issue is backed by a single corporate bond. Hence, these are, in effect, corporate bonds traded on major stock exchanges and available at discount broker commissions.

Because most corporate bonds are traded over the counter, and prices are not published and bid/ask spreads are thought to be wide, most individual investors cannot trade bonds. They must buy bonds and plan to hold them to maturity, selling them only in an emergency due to high trading costs. Trust preferred stocks remove these disadvantages. They can be traded in lots as small as $10, prices are published, and quotes and charts are readily available.

The major disadvantage of trust preferred stocks is that they are usually quoted in the newspaper under the investment bank’s listing (Lehmans, Merrill Lynch, Morgan Stanley) of preferred stocks, or under their company’s tradename (Cabco, CBTCS, Corts, PPlus, Saturns, etc.) for third party trust preferred stocks. One must consult the prospectus to learn the details of the issue, and sometimes, the name of the corporation whose bond supports the issue. QuantumOnLine.com is the best source of this information. Their symbol look-up function will find most of the issues. Once you know the stock ticker, quotes can be obtained from the usual sources.

QuantumOnLine.com now offers a list of Third Party Trust Preferred stocks that include current bond rating, details of call dates, and a link to the original prospectus.  They are available from a wide range of corporations and in a full range of bond ratings. Most are long bonds, but increasingly shorter maturities are becoming available.

Purchasers should be careful to check the call provisions of the issues. Most are callable on or after a specified date, usually at $10 or $25/share. Paying a premium over the call price can result in having the issue called out from under you at a loss. Call prices sometimes hold down the price of an issue resulting in what appear to be above market yields. Due caution is advised of high yield issues.

The uncertainty of issuing investment banks poses questions about the future of these products. Presumably, they are a profitable business not requiring high leverage and likely to be continued by new owners once current financial difficulties are resolved.

What Is An ABS?

An asset-backed security (ABS) is a fixed income instrument structured as a securitized interest in a pool of assets. The 2010 Dodd-Frank financial reform act broadly defined asset-backed securities to encompass all securitizations:

… a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the Commission, by rule, determines to be an asset-backed security for purposes of this section.

Traditionally, finance professionals have used the term more narrowly to refer to securitizations other than mortgage-backed securities (MBS). When collateralized debt obligations (CDOs) and collateralized bond obligations (CBOs) became popular in the early 2000s, they too were excluded from the definition. For the most part, asset-backed securities are understood to be securitizations of auto loans, credit card receivables, home equity loans and student loans.

Asset-backed securities have credit risk. Diversification of the underlying assets, credit enhancements or tranching can mitigate this. Following the 2008 financial crisis, asset-backed securities didn’t suffer nearly the credit losses that MBSs did.

Asset-backed securities 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.

Asset-backed securities are appealing to issuers because the structure allows them to get assets off their balance sheets, freeing up capital for further receivables. However, the Dodd-Frank Act requires issuers of all securitizations to retain some of the credit risk of those instruments. Asset-backed securities do make it possible for issuers whose unsecured debt is below investment grade to sell investment-grade debt.

To create an asset-backed security, a corporation creates a special purpose vehicle to which it sells the assets. While is common to speak of the corporation as the issuer of the asset-backed security (we do so above), it is legally the trust or special purpose vehicle that is the issuer. It is the trust or special purpose vehicle that sells securities to investors.

To protect investors from possible bankruptcy of the corporation, there are three legal safeguards:

  • Transfer of assets from the corporation is a non-recourse, true sale.
  • Investors receive a perfected interest in the assets’ cash flows.
  • A non-consolidation legal opinion is obtained certifying that assets of the trust or special purpose vehicle cannot be consolidated with the corporation’s assets in the event of bankruptcy.

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, asset-backed securities 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. asset-backed securities 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. Choice of structure depends upon investor demand as well as the nature of the underlying assets.


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Definition Sources


Definitions for Asset-Backed Security are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 28th December, 2021 | 0 Views.