Asset-Backed Securities (ABS)
Asset-backed securities, also called ABS, are pools of loans that are packaged and sold as securities – a process known as “securitization.” The type of loans that are typically securitized includes home mortgages, credit card receivables, auto loans, home equity loans, student loans, and even loans for boats or recreational vehicles.
Here’s how it works: when a consumer takes out a loan, their debt becomes an asset on the balance sheet of the lender. The lender, in turn, can sell these assets to a trust or “special purpose vehicle,” which packages them into an asset-backed security that can be sold in the public market. The interest and principal payments made by consumers “pass through” to the investors that own the asset-backed securities. Typically, individual securities are gathered in "Tranches" or groups of other loans with similar ranges of maturities and delinquency risks.
The benefit for the issuer of an ABS is that the issuer removes these items from its balance sheet, thereby gaining both a source of new funds as well as greater flexibility to pursue new business. The benefit to the buyer – usually institutional investors – is that they can pick up additional yield relative to government bonds and augment their portfolio diversification. While this is a worthwhile aim, historically, some ABS have turned out to be very bad investments -- it was the meltdown of ABS holding sub-prime mortgages that initiated the Great Recession that began in late 2007.
The ABS market first developed in the 1980s, and it has since grown to be a significant component of the U.S. debt market. The U.S. ABS Index was created in 1992, at which point the asset class was added to the Lehman U.S. Aggregate Bond Index – the benchmark for investment-grade bonds that is now called the Barclays U.S. Aggregate Bond Index. During the past decade, asset-backed securities have made up anywhere from 2.5% to 7% of the index.
Only financially sophisticated, wealthy individual investors should buy individual asset-backed securities directly. Evaluating the underlying loans requires considerable research and acquiring the necessary data isn't always straightforward. However, if you own a bond mutual fund, particular an index fund, there’s a good chance that the portfolio has a modest weighting in ABS. There are also a number exchange-traded funds dedicated solely to asset-backed securities, among them the Vanguard Mortgage-Backed Securities ETF (VMBS), which holds mortgage-backed pass-through securities issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC) with maturities ranging from 3 to 10 years. It is a relatively safe ABS fund with a low 0.10% management fee.
ABS carry some prepayment risk, which is the chance that investors will experience reduced cash flows caused by borrowers paying off their loans early, particularly in a declining interest rate environment when borrowers can refinance existing loans with new, lower interest-rate loans.
The mixed history of ABS securities suggests that some caution needs to be exercised even when buying AAA or AA rated ABS since in the past the credit ratings attached to some of these by Moody's and others has not always been reliable. It's also prudent to buy ABS ETFs only from large, highly-regarded issuers, such as Vanguard, and to invest in investment-grade products.