Asset-Backed Securities (ABS) offer an opportunity for investors to enhance the return and diversify the risk of their portfolio. This white paper provides insights into this asset class. What are ABS, how are ABS structured and what are the characteristics of the European ABS market in particular? This analysis can help investors to better understand the asset class, including its opportunities and risks.
What is an ABS and how is an ABS structured? ABS are loans ('securities') that are covered ('backed') by a specific collateral (a pool of 'assets'). The underlying loans, such as residential mortgages or credit card loans, are often split into different risk tranches. The losses on the pool of assets are first absorbed by the higher-risk tranches but these tranches also have a higher return potential, see Figure 1. The availability of the characteristics of the underlying loan portfolio makes it possible for investors to perform in-depth risk analyses. This gives investors the opportunity to select an ABS that corresponds with their risk and return preference.
Figure 1: Illustration of a pay-through structure with mortgage loans as collateral.
The risk profile of ABS is characterized by their variable interest payments (floating rate coupons). This makes the interest rate risk of an ABS substantially lower than for sovereign or corporate bonds. Depending on the overall interest rate hedging policy, the short duration can make ABS an attractive investment in a scenario of rising interest rates. Another feature of an ABS is that the credit risk is not caused by countries or companies, but predominantly by consumers. Because of this exposure to consumer risk, ABS offer an attractive opportunity for risk diversification within the fixed income portfolio.
The euro-denominated ABS market is very diverse in terms of the underlying collateral. For this reason, the different market segments are defined according to the type of underlying loans. The majority of the market consists of Residential Mortgage-Backed Securities (RMBS) and Consumer ABS (securities backed by car loans, credit card loans or student loans), see Figure 2.
Figure 2: Breakdown of the outstanding euro-denominated ABS market by sector, as of 31 December 2017. Source: AFME Securitisation Data Report 2017: Q4, via https://www.afme.eu/en/reports/Statistics/securitisation-data-report-q4-2017/
The United Kingdom, Spain and Italy are strongly represented as issuers of European ABS and most securities have a high rating (from A up to AAA). However, within segments of the market, the distribution over countries and ratings differs strongly. This helps to create an ABS portfolio that is well-diversified over segments, countries and ratings and that meets the risk-return preferences of an investor.
- The availability of the characteristics of the underlying loan portfolio gives investors the opportunity to perform in-depth risk analyses and to select an ABS that meets their risk-return preferences.
- Because of their exposure to consumer risk, ABS offer risk diversification within the fixed income portfolio.
- The distribution over countries and ratings in the segments of ABS market differs strongly. This gives investors the opportunity to create an ABS portfolio that is well-diversified.