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Asset Backed Security (ABS)

What is Asset Backed Security (ABS)?

An Asset Backed Security (ABS) is a type of financial instrument that is backed by a pool of underlying assets such as loans, leases, credit card debt, or receivables. These assets generate regular cash flows, which are then used to pay interest and repay principal to investors.

Key Features

  • ABS are created through a process called securitization, where illiquid assets are converted into tradable securities.
  • They typically have a fixed maturity period and pay periodic interest to investors.
  • ABS are structured in tranches, with different levels of risk and returns (e.g., senior, mezzanine, and junior tranches).
  • Rating agencies usually assign credit ratings to ABS based on the quality of underlying assets and credit enhancements.

Common Underlying Assets

  • Auto loans
  • Credit card receivables
  • Home loans (other than those classified as Mortgage Backed Securities)
  • Student loans
  • Equipment leases

Purpose and Benefits

The main objective of issuing ABS is to provide liquidity to the originators (e.g., banks, NBFCs) by moving assets off their balance sheets. For investors, ABS offer opportunities to earn fixed income returns from diversified pools of assets, often with higher yields than traditional debt instruments.

Risks Involved

  1. Credit Risk: If borrowers default, the cash flows supporting the ABS may be disrupted.
  2. Prepayment Risk: Early repayment of loans can affect the expected return.
  3. Complexity: ABS structures can be complicated, and understanding the underlying asset quality is crucial.

Example

A finance company pools together hundreds of car loans it has issued and securitizes them into an ABS. Investors who buy the ABS receive payments based on the EMIs paid by the car loan borrowers.

Indian Context

In India, ABS are commonly issued by Non-Banking Financial Companies (NBFCs) to raise capital. The Reserve Bank of India (RBI) has laid down specific guidelines on securitization, ensuring transparency and protecting investor interests.