Insights

Asset-backed securities (ABS) are a type of structured credit instrument where bonds are backed by underlying pools of assets such as mortgages, loans or other corporate or consumer debt. A portfolio of comparable assets are grouped together and held by a Special Purpose Vehicle (SPV). These are then securitised with the bonds backed by the asset portfolio -sold to investors in the market. 

The coupons paid on the asset-backed security come from the cash flows received from the interest and principal payments made on the underlying assets. As such, the bond is “backed” by the principal and interest flowing from the asset pool. ABS backed by the same asset portfolio are usually structured into multiple tranches with different risk-return profiles and credit ratings. Senior tranches are structured with the lowest credit risk but offer lower returns, while junior (mezzanine or equity) tranches have higher risk but potentially higher returns.  

ABS make up an important part of the fixed income universe and can help to improve the efficiency of the financial system, allowing banks and other lenders to fund their lending portfolios. Since its inception in the 1970s, the global asset-backed securities market has grown significantly, particularly in recent years, reaching a size of ~US$13tn in 2024 with ~US1.2bn of issuance. Securitised markets are expected to continue to grow strongly in coming years, providing investors with attractive investment opportunities across diverse risk and return profiles.

The ABS asset class has complexity due to the significant experience and analysis required to understand the underlying asset portfolios, structures and documentation behind ABS bonds.

Looking deeper: What is ABS?

The term “asset-backed security” is an umbrella term encompassing a wide variety of securitised debt products. A broad range of assets can be pooled in ABS transactions. These include more granular consumer assets such as mortgages, auto loans, equipment loans, small business loans and credit card receivables. The asset class also offers funding for more esoteric assets such as aircraft leases and newer sectors such as data centres and solar panel financing.

Below are explanations of commonly referenced types of ABS:

Residential mortgage-backed security (RMBS): The ABS bond is backed by a diversified pool of residential mortgages. In this case, the coupon paid by an RMBS bond comes from the interest and principal payments made by individuals on their mortgage.

Commercial mortgage-backed security (CMBS): The ABS bond is backed by a diversified pool of commercial mortgages, such as mortgages on office buildings, hotels and retail centres.

Auto ABS: The ABS bond is backed by a diversified pool of car loans, which may be new or used. 

Collateralised loan obligation (CLO): Tranched security backed by a diversified pool of senior secured loans to non-financial high yield borrowers. The underlying portfolio of loans is actively managed by firms specialising in the credit underwriting and monitoring of these assets.

Collateralised debt obligation (CDO): Tranched security backed by pools of mezzanine ABS bonds, themselves backed by pools of residential mortgages. Structures backed by subprime mortgage mezzanine bonds saw significant losses during the Global Financial Crisis (GFC) and are mostly legacy instruments. Lessons learnt from issues around transparency, incentives and performance of these structures fed into the increased regulatory oversite and regulations introduced to global securitisation markets after the GFC.

Opportunities within ABS

Favourable risk-return dynamics: ABS offers a typically higher yield than similarly rated corporate credit. This is partly as a result of its higher complexity requiring a specialised skillset and resourcing.
Wide breadth of opportunities: Relative value opportunities exist across geographies, asset classes and capital structures:

• Diverse set of underlying collateral types across developed markets
• Opportunity set spans AAA to equity risks
• Opportunities exist across both public and private markets

Short duration: Most ABS securities issued in European and Australian markets are floating rate which means not only higher returns in a rising rate environment but also lower duration relative to traditional fixed income.

Shorter repayment: Typically, repayments are within 1 to 5 years, much faster than traditional corporate credit exposures. This reduces the underlying volatility and correlation of asset backed finance with traditional growth assets as well as traditional fixed income products due to the insulation from interest rate and credit spread duration risk.

Risks in ABS

ABS is a complex asset class and involve a number of risks, including:

Credit risk: ABS are backed by assets and therefore their value depends on the creditworthiness of the underlying assets. Defaults in the collateral pool will affect ABS performance. As such, it is important to understand the credit quality and risk of default of the underlying assets. In-depth analysis of granular data on asset pools can help determine this.

Market risk: As with other financial securities, ABS prices can move in response to the market and economic environment and investor sentiment. 

Liquidity risk: While the ABS market has been grown to be relatively large and deep, some ABS can have limited liquidity, particularly during periods of market turmoil. It is important to be aware of the liquidity environment for different ABS. 

Prepayment risk: For ABS backed by assets such as mortgages, borrowers may repay their loans ahead of schedule, impacting the expected cash flows. Cash flow modelling and structural features can help to mitigate the impact of prepayment risk.

Extension risk: Given ABS cash flows can be long dated, for example backed by mortgages, transactions may be reliant on a call option being met by the Issuer/Sponsor to repay the bonds at their shorter expected maturity dates. The event of a non-call at such date could mean bonds extend beyond these expected maturities. Call protections or structural features are included in many transactions to give investors more comfort around extension risk and may include features to compensate investors such as a step up in coupons in the event it occurs.

Interest rate risk: Most ABS issued in European and Australian markets are floating rate, so while their market prices are not typically impacted directly by rising or falling interest rates, the total coupon paid on the ABS will fluctuate as floating reference rates change. Underlying asset performance, such as prepayment rates and arrears, can also be impacted by changes in interest rates. Where floating rate ABS bonds are backed by portfolios of fixed rate loans, transactions also typically contain interest rate derivatives such as interest rate swaps to mitigate this mismatch, backed by highly rated institutional counterparties.

Risk management in ABS 

Despite the risks in the asset class, ABS are usually structured with investor-friendly features to help protect against loss. These include:

Bankruptcy remoteness: The assets backing ABS are isolated from the issuer’s bankruptcy. Typically, the underlying assets are housed in a bankruptcy remote trust, meaning that the assets in the trust cannot be seized by the issuer’s creditors if the issuer files for bankruptcy. 

Diversity and quality of underlying assets: ABS should be structured with high quality and diverse pools of collateral in order to minimise the likelihood and impact of defaults in specific sectors or regions. 

Credit enhancements, including:

• Subordination: Refers to the ranking of different ABS tranches in order of priority of payment. Senior tranches have higher priority of payment than junior tranches, which absorb losses first and provide credit support for senior tranches. A higher level of subordination means higher credit protection for investors in that tranche.
• Excess spread: The difference between interest collected from underlying assets and the interest paid to investors, providing a buffer against losses. A higher level means higher credit protection for investors.
• Overcollateralization: When the face value of the assets in the underlying loan pool exceeds the par value of the issued bonds, meaning the transaction can still make required principal and interest payments even if some payments from underlying loans are late or default. 

Structural features: ABS are often embedded with structural features to protect investors. An example is sequential payment of the bonds. Transactions that pay down sequentially, with senior notes paying down first, increase credit enhancement via subordination for mezzanine notes over time.  Transactions such as these also become less economically viable for Issuers as senior (cheaper) notes pay down, increasing the likelihood of the deal being refinanced at expected maturity. 

Evolution of ABS since the Global Financial Crisis (GFC)

Prior to the Global Financial Crisis (GFC), some risks in ABS were generally underappreciated, particularly those around subprime mortgages and CDOs. Lessons learnt from the GFC have been incorporated widely across ABS sectors and deal structures have improved markedly, resulting in significantly improved transparency and lower credit risk. 

Improvements in ABS since the GFC include:

• Better underwriting standards for the underlying loan pools have generally reduced credit risk. Asset stress testing and loan suitability standards have become much more rigorous. For example, increased regulation around mortgage affordability.
• Structural changes have increased required credit enhancements, improving the loss coverage across ABS tranches.
• Increased regulatory oversight has better aligned issuer and investor incentives, leading to better transparency in the asset class. 
• Loan and performance data has become much more widely available, allowing access to highly granular data on loan pools for in-depth analysis.
• ESG Europe has been at the forefront of ESG integration in the ABS space over recent years, driven by regulatory focus and investor demand.

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