Securitization is the process where issuers design a marketable financial instrument by pooling several financial assets into one group. Then, they sell the group of repackaged assets to investors. There are various types of securities that come as a result of securitization. Among those, one is the asset-backed securities.
What is Asset-Backed Securities?
Asset-backed securities (shortly known as ABS) represents a pool of loans that issuers package and sell to investors as securities. These securities come as a direct result of securitization. Asset-backed securities typically consist of home mortgages, credit card receivables, auto loans, home equity loans, and student loans.
Asset-backed securities have a pool of underlying assets. Issuers cannot sell most of the above types of loans separately. Therefore, they use asset-backed securities to securitize them. It provides investors with even further investment opportunities. Similarly, it allows issuers to remove any risky assets they have from their balance sheets.
Most bond mutual funds or index funds expose investors to asset-based securities. Some exchange-traded funds also trade based solely on asset-backed securities.
How do Asset-Backed Securities work?
When borrowers take out a loan, it is their liability. For the issuer or lender, however, it is an asset on their balance sheet. However, the transaction does not stay between the borrower and the lender. The lender in this transaction can further sell the assets to other parties. These parties then package these assets into asset-backed security that they sell in the public market. Investors that own asset-backed securities receive payments when the borrower makes principal and interest payments.
What are the advantages of Asset-Backed Securities?
There are various advantages of asset-backed securities. Firstly, they reduce the risks associated with investing in debt instruments, such as default or credit risks. Investors receive interest and principal payments from various assets without having to take direct risks from them. It is because asset-backed securities expose investors to only a portion of the risks that come with the underlying assets.
Due to the lower risks, higher returns, and more stability, investors can also use asset-backed securities as an alternative to government bonds. Investors looking to develop a diversified portfolio of investments can also provide these securities in their portfolios.
Similarly, by providing asset-backed securities, lenders can remove any risky loans from their financials. It is because lenders securitize the loans to repackage and sell them to investors. Through this, they can also generate more funds to issue even more loans for their business. This way, the lender also gets a benefit from these securities.
What are the disadvantages of Asset Based Securities?
Despite the advantages, asset-based securities also come with some disadvantages. For some investors, they work out great. However, there are also practical examples of these securities failing, especially during the Great Recession. These investments aren’t for everyone. Since these securities come with underlying loans, it requires investors to perform considerable research beforehand. The data is not usually available like other securities.
Asset-based securities also come with prepayment risks. It represents the chance that investors may experience reduced cash flows due to early payments by borrowers. This risk is higher when borrowers can refinance their existing loans at lower rates.
Asset-backed securities are a pool of loans, packaged and sold by issuers. They come as a result of a process known as securitization. Asset-based securities can be advantageous for both investors and lenders. However, they also come with some disadvantages, as discussed above.
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