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Asset-Backed Security (ABS)

A financial investment known as an asset-backed security (ABS) is one that is secured by a pool of underlying assets, typically those that produce a cash flow from debt such loans, leases, credit card balances, or receivables. It takes the shape of a bond or note and provides income at a fixed rate till maturity over a predetermined period of time. Asset-backed securities can be a substitute for other debt products, such as corporate bonds or bond funds, for income-seeking investors.

Understanding Asset Backed Securities
Asset-backed securities (or ABS) are a type of security that is backed by assets.
The acronym "ABS" refers to a specific type of security that is backed by the collateral of an underlying asset, such as a securitized loan.
The income (i.e. cash flows) used to make the regular interest payments, obligatory principle amortization, and full repayment of the principal at maturity is generated by the assets pledged as security.
Lenders have the legal right to take possession of the collateral in order to recuperate some or all of their initial investment if the borrower fails to fulfill its debt commitments. This includes failing to make interest or principal payments when due.
When debtors pledge assets as security for debt, the lender is given a lien on (i.e., a "right to") those assets, allowing the lender to take possession of those assets in the event of a borrower default.
When debt is secured by assets, the lender's downside risk is mitigated and the financing carries less of an overall risk. That's why asset-backed debt typically comes with better rates and terms than unsecured loan financing does.


Cases of ABS Collateral
Debt securities typically have highly liquid assets as collateral, which means that they may be quickly and readily converted into cash without losing a considerable amount of value in the process.
Cash and other cash equivalents (such as marketable securities and commercial paper) are the most liquid current assets.
Typical ABSs consist of the following types of assets:
  • Auto Loans
  • Home Equity Loans
  • Student Loans
  • Real Estate Mortgages
  • Credit Card Receivables
  • Classes of Asset Backed Securities (ABS)

Types of asset-backed securities
MBS stands for "mortgage-backed security," which refers to a bond issuance backed by a pool of mortgage loans.
Mortgage-backed debt instruments (MBS) from which interest and principal payments are derived from mortgages on single-family homes.
The term "commercial mortgage-backed securities" (CMBS) refers to mortgage-backed debt securities that are secured by loans on business real estate as opposed to residential real estate.
Debt issuances known as a Collateralized Loan Obligation (CLO) are backed by a pool of assets made up of corporate loans that have poorer credit ratings and are commonly linked to mergers and acquisitions (M&A), specifically loans used to finance leveraged buyouts (LBOs).
The term "collateralized debt obligation" (CDO) refers to a class of complex debt securities that are backed by a pool of assets rather than a single security.
Institutional investors are the traditional buyers of structured finance products like collateralized debt obligations (CDOs).
Individual investors can choose the tranche they wish to invest in for these securities.
To illustrate, senior tranches are less risky than the junior tranches, but may entail a lower projected return on investment for the lender, and vice versa, depending on where the claim falls in the priority hierarchy.
The term "subordination" is used to describe the structure used in securitization, which involves a hierarchical ordering of claims in the form of separate classes or tranches.

Collateralized loan obligation is an example of asset-backed securities (CLO)
Asset-backed securities include collateralized loan obligations (CLOs), which are backed by a pool of business loans with low credit ratings.
During the CLO securitization process, low-credit-rating corporate loans are bundled together with the idea that the increased loan diversification will reduce the overall credit risk.
The CLOs will have many "tranches," or separate investment classes, so they may cater to investors with different risk tolerances.
A financial institution will establish a special-purpose vehicle (SPV) to acquire corporate loans from borrowers like private equity firms and bundle these loans together into a collateralized loan obligation (CLO).
When this is done, the CLO will be broken down into its component parts, or tranches, and sold to institutional investors.

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