An Asset-Backed Security, or ABS, is a form of debt security backed by a pool of underlying, cash-flow producing assets. For investors, asset-backed securities are an alternative to investing in corporate debt. An ABS is essentially the same thing as a mortgage-backed security, except that the securities backing it are assets such as loans, leases, credit card debt, a company's receivables, royalties and so on, and not mortgage-based securities.
Underlying collateral for ABS frequently includes:
- Auto Loans
- Credit Card Receivables
- Student Loans
Companies that issue these loans or receivables sell them to securities dealers which package them into ABS. These companies typically benefit by having new cash on hand that they can use to issue more loans.
Tranches will be created with differing yields and seniority rights to the cash flows, and sold to investors or institutions depending on risk profile. In a sequential payout structure, all principal payments will go to the senior tranche until those holders are fully paid off before principal payments flow down the ladder to the mezzanine, and then subordinate, tranches. Likewise, senior tranches have claim on interest payments, and interest cash flows can be diverted from the subordinate tranches to more senior tranches to make up any shortfall. To compensate the mezzanine and subordinate tranches for the increased risk of loss due to cash flow shortfalls, they receive higher interest rates than the senior tranche.
For more information about ABS, visit ABS Basics at fixed income giant PIMCO's website.
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