Asset-Backed Securities (ABS)

Asset-backed securities, also called "ABS," are pools of loans that are packaged and sold to investors as securities—a process known as “securitization.” The type of loans that are typically securitized includes home mortgages, credit card receivables, auto loans (including loans for recreational vehicles), home equity loans, student loans, and loans for boats.

Asset-Backed Securities: How They Work

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 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 into "tranches" or groups of loans with similar ranges of maturities and delinquency risks.

The ABS market first developed in the 1980s. In 1986, mortgage-backed securities were added to the investment-grade bond index that later became known as the Barclays U.S. Aggregate Bond Index.

If you own a bond mutual fund, particularly an index fund, there’s a good chance that the portfolio includes exposure to ABS. There are also a number of 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 three to ten years. It is a relatively safe ABS fund with an expense ratio of 0.07%.

ABS Benefits

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.

ABS Risks 

While some investors have success with ABS investments, some ABS have historically turned out to be bad investments. It was the meltdown of ABS holding sub-prime mortgages that initiated the Great Recession that began in late 2007.

Only financially sophisticated, wealthy investors should buy individual asset-backed securities directly. Evaluating the underlying loans requires considerable research, and the process of acquiring the necessary data isn't always straightforward.

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 low-yield environment when borrowers can refinance existing loans at lower rates.

The mixed history of ABS securities suggests that some caution needs to be exercised, even when buying AAA or AA rated ABS. In the past, the credit ratings attached to ABS by Moody's and other rating agencies have not always been reliable. It's also prudent to only buy ABS ETFs from large, highly regarded issuers, such as BlackRock, Fidelity, or Vanguard, and to invest in investment-grade products.