You may not know this, but it’s quite likely that the bond side of your portfolio has exposure to this type of security. Like the name implies, an asset-backed security, or ABS for short, is a security backed by a loan, lease, or receivables (incoming cash) against a non-real-estate/mortgage-backed asset. This type of security provides investors with access to various income-generating assets such as loans, leases, credit card debt, or royalties. To securitize these assets, lenders will pool them together, thereby creating a financial security that can be marketed to investors.
How does this work in real life? Let’s say there’s a bank that makes loans to small companies and they’ve made so many loans that they’ve run out of cash to make any more. They can sell those loans to an investment firm in exchange for cash that allows them to make more loans. The investment firm will then combine those loans based on similar characteristics of the loans. The investment firm then makes these securities available to investors who receive the cash flow from borrowers paying back the loans (less an administrative fee).
While asset-backed securities sound complicated and exotic, the structure behind them is actually quite simple and straightforward. Not only that, but investing in them provides another way for investors to generate income while diversifying their investments. If you’d like to learn more about how we invest, please feel free to look at some of our other articles or give us a call.