Introduction To Asset-Backed Securities (ABS)

ABS have evolved out of  mortgage backed securities (MBS) and are created from the pooling of non-mortgage assets. These are usually backed by credit card receivables, home equity loans, student loans and auto loans. The ABS market was developed in the 1980s and has become increasingly important to the U.S. debt market.

StructureThere are three parties involved in the structure of ABS and MBS: the seller, the issuer and the investor. Sellers are the companies that generate loans and sell them to issuers. They also take the responsibility of acting as the servicer, collecting principal and interest payments from borrowers. Issuers buy loans from sellers and pool them together to issue ABS or MBS to investors. They can be a third-party company or special-purpose vehicle (SPV). ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to acquire additional funding. Investors of ABS and MBS are usually institutional investors and they use ABS and MBS to obtain higher yields than government bonds, as well as to provide a way to diversify their portfolios
Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS. Prepayment risk is the risk of borrowers paying more than their required monthly payments, thereby reducing the interest of the loan. Prepayment risk can be determined by many factors, such as the current and issued mortgage rate difference, housing turnover and path of mortgage rate. If the current mortgage rate is lower than the rate when the mortgage was issued or housing turnover is high, it will lead to higher prepayment risk. The path of the mortgage rate might be difficult to understand, so we will explain with an example. A mortgage pool begins with a mortgage rate of 9%, then drops to 4%, rises to 10% and finally falls to 5%. Most homeowners would refinance their mortgages the first time the rates dropped, if they are aware of the information and are capable of doing so. Therefore, when the mortgage rate falls again, refinancing and prepayment would be much lower compared to the first time. Prepayment risk is an important concept to consider in ABS and MBS. Therefore, to deal with prepayment risk, they have tranching structures, which help by distributing prepayment risk among tranches. Investors can choose which tranche to invest based on their own preferences and risk tolerance.

Valuation It is important to measure the spread and pricing of bond securities and know which type of spread should be used for different types of ABS and MBS for investors. If the security doesn't have embedded options that are typically exercised, such as call, put or certain prepayment options, the zero-volatility spread (Z-spread) can be used to measure them. The Z-spread is the constant spread that makes the price of a security equal to the present value of its cash flow when added to each Treasury spot rate. For example, we can use the Z-spread to measure credit card ABS and auto loan ABS. Credit card ABS don't have any options, hence the Z-spread is appropriate.

The Bottom LineAsset-backed and mortgage-backed securities are complicated in terms of their structures, characteristics and valuations. Investors who want to invest in these securities can buy into property bonds such as the U.S Social Housing Bond. If you want to invest in ABS or MBS directly, makes sure you do a good deal of research, be confident of what you are doing and make sure your investment matches your risk tolerance.