What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Understanding Asset-Backed Securities (ABSs)

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can’t be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans, or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren’t available in any other investment.

How an Asset-Backed Security Works

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use to make more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

Special Considerations

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

• Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
• Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
• Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt. 
• Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.
• Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn’t qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

Auto Loan ABS

Car financing is another large category of ABS. The cash flows of an auto loan ABS include monthly interest payments, principal payments, and prepayments (though the latter is rarer for an auto loan ABS is much lower when compared to a home equity loan ABS). This is another amortizing loan.

Credit Card Receivables ABS

Credit card receivables—the amount due on credit card balances—are a type of non-amortizing asset ABS: They go to a revolving line of credit, rather than towards the same set sum. So they don’t have fixed payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually a lock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the lock-up period, the principal payment is passed on to ABS investors.

Student Loan ABS

ABSs can be collateralized by either government student loans, guaranteed by the U.S. Dept. of Education, or private student loans. The former have had a better repayment record, and a lower risk of default.

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

The Bottom Line

Asset Backed Securities (ABS) are pools of loans that are packaged together into an investable security, which can in turn be bought by investors, predominantly large institutions, like hedge funds, insurance companies, and pension funds. ABS provide a method of diversification from typical bond mutual funds or individual bonds themselves. Most importantly, they are income generating assets, typically with a higher return than a normal corporate bond, all depending on the credit rating assigned to the ABS.

The underlying assets of an ABS could consist of auto loans, credit card receivables, and even more exotic investments, such as utility bills and toll roads. Such categories of ABS are referred to by different names such as CDO’s (Collateralized Debt Obligations), which are broken down into further sub-categories, such as CLO’s (Collateralized Loan Obligations). However, by far, the most popular and therefore liquid ABS are MBS (Mortgage Backed Securities), which provide an income stream from mortgage payments.

For the investor, ABS provide an income stream in line with the credit rating of the security, and offer an alternative to standard bond mutual funds.

What Is Asset Management?

Asset management is the practice of increasing total wealth over time by acquiring, maintaining, and trading investments that have the potential to grow in value.

Asset management professionals perform this service for others. They may also be called portfolio managers or financial advisors. Many work independently while others work for an investment bank or other financial institution.

Understanding Asset Management

Asset management has a double-barreled goal: increasing value while mitigating risk. That is, the client’s tolerance for risk is the first question to be posed. A retiree living on the income from a portfolio, or a pension fund administrator overseeing retirement funds, is (or should be) risk-averse. A young person, or any adventurous person, might want to dabble in high-risk investments.

Most of us are somewhere in the middle, and asset managers try to identify just where that is for a client.

The asset manager’s role is to determine what investments to make, or avoid, to realize the client’s financial goals within the limits of the client’s risk tolerance. The investments may include stocks, bonds, real estate, commodities, alternative investments, and mutual funds, among the better-known choices.

The asset manager is expected to conduct rigorous research using both macro and microanalytical tools. This includes statistical analysis of prevailing market trends, reviews of corporate financial documents, and anything else that would aid in achieving the stated goal of client asset appreciation.

Types of Asset Managers

There are several different types of asset managers, distinguished by the type of asset and level of service that they provide. Each type of asset manager has a different level of responsibility to the client, so it is important to understand a manager’s obligations before deciding to invest.

Registered Investment Advisers

A registered investment adviser (RIA) is a firm that advises clients on securities trades or even manages their portfolios. RIAs are closely regulated and are required to register with the SEC if they manage more than $100 million in assets.

Investment Broker

A broker is an individual or firm that acts as an intermediary for their clients, buying stocks and securities and providing custody over customer assets. Brokers generally do not have a fiduciary duty to their clients, so it is always important to thoroughly research before buying.

Financial Advisor

A financial advisor is a professional who can recommend investments to their clients, or buy and sell securities on their behalf. Financial advisors may or may not have a fiduciary duty to their clients, so it is always important to ask first. Many financial advisors specialize in a specific area, such as tax law or estate planning.

Robo-Advisor

The most affordable type of investment manager isn’t a person at all. A robo-advisor is a computer algorithm that automatically monitors and rebalances an investor’s portfolio according, selling and buying investments according to programmed goals and risk tolerances. Because there is no person involved, robo-advisors cost much less than a personalized investment service.

How Much Does Asset Management Cost?

Asset managers have a variety of fee structures. The most common model charges a percentage of the assets under management, with the industry average at about 1% for up to $1 million, and lower for larger portfolios. Others may charge a fee for each trade they execute. Some may even receive a commission to upsell securities to their clients.

Because these incentives can work against the client’s interests, it is important to know if your management firm has a fiduciary duty to serve the client’s interests. Otherwise, they may recommend investments or trades that do not serve the client’s interests.

How Asset Management Companies Work

Asset management companies compete to serve the investment needs of high-net-worth individuals and institutions.

Accounts held by financial institutions often include check-writing privileges, credit cards, debit cards, margin loans, and brokerage services.

When individuals deposit money into their accounts, it is typically placed into a money market fund that offers a greater return than a regular savings account. Account-holders can choose between Federal Deposit Insurance Company-backed (FDIC) funds and non-FDIC funds.

The added benefit to account holders is all of their banking and investing needs can be met by the same institution.

These types of accounts have only been possible since the passage of the Gramm-Leach-Bliley Act in 1999, which replaced the Glass-Steagall Act. The Glass-Steagall Act of 1933, passed during the Great Depression, forced a separation between banking and investing services. Now, they have only to maintain a “Chinese wall” between divisions.

Example of an Asset Management Institution

Merrill Lynch offers a Cash Management Account (CMA) to fulfill the needs of clients who wish to pursue banking and investment options with one vehicle, under one roof.

The account gives investors access to a personal financial advisor. This advisor offers advice and a range of investment options that include initial public offerings (IPO) in which Merrill Lynch may participate, as well as foreign currency transactions.

Interest rates for cash deposits are tiered. Deposit accounts can be linked together so that all eligible funds aggregate to receive the appropriate rate. Securities held in the account fall under the protective umbrella of the Securities Investor Protection Corporation (SIPC). SIPC does not shield investor assets from inherent risk but rather protects those assets from the financial failure of the brokerage firm itself.

Along with typical check writing services, the account offers worldwide access to Bank of America automated teller machines (ATM) without transaction fees. Bill payment services, fund transfers, and wire transfers are available. The MyMerrill app allows users to access the account and perform a number of basic functions via a mobile device.

Accounts with more than $250,000 in eligible assets sidestep both the annual $125 fee and the $25 assessment applied to each sub-account held.

Frequently Asked Questions

The Bottom Line

Asset management firms provide the service of buying and selling assets on behalf of their clients. There are many types of asset managers, with some working for family offices and wealthy individuals and others working on behalf of major banks and institutional investors.

What Is an Autoregressive Model?

A statistical model is autoregressive if it predicts future values based on past values. For example, an autoregressive model might seek to predict a stock’s future prices based on its past performance.

Understanding Autoregressive Models

Autoregressive models operate under the premise that past values have an effect on current values, which makes the statistical technique popular for analyzing nature, economics, and other processes that vary over time. Multiple regression models forecast a variable using a linear combination of predictors, whereas autoregressive models use a combination of past values of the variable.

An AR(1) autoregressive process is one in which the current value is based on the immediately preceding value, while an AR(2) process is one in which the current value is based on the previous two values. An AR(0) process is used for white noise and has no dependence between the terms. In addition to these variations, there are also many different ways to calculate the coefficients used in these calculations, such as the least squares method.

These concepts and techniques are used by technical analysts to forecast security prices. However, since autoregressive models base their predictions only on past information, they implicitly assume that the fundamental forces that influenced the past prices will not change over time. This can lead to surprising and inaccurate predictions if the underlying forces in question are in fact changing, such as if an industry is undergoing rapid and unprecedented technological transformation.

Nevertheless, traders continue to refine the use of autoregressive models for forecasting purposes. A great example is the Autoregressive Integrated Moving Average (ARIMA), a sophisticated autoregressive model that can take into account trends, cycles, seasonality, errors, and other non-static types of data when making forecasts.

Example of an Autoregressive Model

Autoregressive models are based on the assumption that past values have an effect on current values. For example, an investor using an autoregressive model to forecast stock prices would need to assume that new buyers and sellers of that stock are influenced by recent market transactions when deciding how much to offer or accept for the security.

Although this assumption will hold under most circumstances, this is not always the case. For example, in the years prior to the 2008 Financial Crisis, most investors were not aware of the risks posed by the large portfolios of mortgage-backed securities held by many financial firms. During those times, an investor using an autoregressive model to predict the performance of U.S. financial stocks would have had good reason to predict an ongoing trend of stable or rising stock prices in that sector. 

However, once it became public knowledge that many financial institutions were at risk of imminent collapse, investors suddenly became less concerned with these stocks’ recent prices and far more concerned with their underlying risk exposure. Therefore, the market rapidly revalued financial stocks to a much lower level, a move which would have utterly confounded an autoregressive model.

It is important to note that, in an autoregressive model, a one-time shock will affect the values of the calculated variables infinitely into the future. Therefore, the legacy of the financial crisis lives on in today’s autoregressive models.

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