Asset-Backed Securities (ABS)
What it is:
The ABS market is not always as overvalued as the markets for other income-producing securities such as corporate bonds or Treasuries. For this reason, investors must carefully examine the features and underlying assets of a particular ABS before investing.
Note that the ABS are subject to prepayment risk; that is, if any of the borrowers pay their cars off early, this reduces the cash flows ultimately going to the ABS investors.
How it works (Example):
But if Company XYZ wants to make more loans, it may find itself needing cash to do so. This is where asset-backed securities come in.
ABC Investments may group these auto loans into tranches--groups of loans that may have common characteristics such as maturity or delinquency risk. ABC then issues a security similar to a bond that essentially keeps an administrative fee for itself and then "forwards" the remaining proceeds from the auto loans to the investors.
The asset-backed securities trade on various exchanges, similar to any other security. Public ABS offerings must satisfy SEC requirements including providing regular financial disclosures to investors. Ratings agencies may assign a rating to the securities based largely on the probability that the underlying expected cash flows will materialize. In some cases, the ABS will receive higher credit ratings than the issuer has for itself; this is a reflection of the risk associated with the certainty of the ABS's underlying cash flows.