A financial security backed by home equity loans, leases, a company’s receivables, credit card debt and royalties among others except real estate or mortgage backed securities is referred to as asset backed securities (ABS). The difference between asset backed securities and mortgage backed securities is that ABS allows the issuer to generate income that can be used to broad base lending and provides investors with opportunities to invest in a range of income generating products.
How Asset Backed Securities Function
- The assets of an ABS cannot be sold on their own. Therefore ABS issuers turn their loans to marketable securities by combining assets and creating a financial security referred to as securitization enabling the owners of the assets to market them. Issuers of ABS are known to be creative in putting together various products that generate cash flows.
- The process. Three parties are needed to structure an ABS. The seller, the issuer and the investor. The sellers are the companies and institutions that generate loans and sell them to issuers. The issuers buy the loan from sellers, package and sell them to investors as ABS. Issuers can be special purpose vehicles (SPV) or third party companies. Institutional investors are the main buyers of ABS as their yields are higher than government bonds. They also offer ways to diversity a company’s investment portfolio.
- Cash Flow Modeling. Use of cash flow software for modeling to unravel the complexities and to evaluate and analyze ABS is critical to the success of the product. The cash flow structure of the many loans and receivables that make up the product needs to be transparent in order to enable investors to carry out cash flow analysis to monitor performance of their assets, maximize returns and manage risks.
- From the standpoint of returns, ABS is among the most profitable investment options. They are based on collateral and internal and external structural features are worked into packages to ensure obligations are met. They are evaluated and rated according their ability to pay interest and the principal as scheduled. These features have gone a long way towards ensuring their acceptability in the debt market. Putting together asset backed securities to raise funds instead of relying on bank loans enable companies to reduce financial costs.
- The asset backed securities consider mortgages as a different loan category and as such are treated as a separate investment.
- As ABS is backed by tangible assets they should be inured from event risk downgrades due to mergers, acquisitions, restructuring and recapitalization that affects the corporate bond market.
- Future of ABS. Better data management, higher quality data analytics and rigorous stress testing improving risk management is the way forward for the ABS market to avoid pitfalls and to win more investors.
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