Asset Backed Securities(ABS)
are a fairly new wave of financial securities anchored and Collaterised Debt Obligations
(Loan assets that have collateral) incorporated into the financial market around 1980. There are two main categories of asset
backed securities
- Consumer loans and receivables which includes mortgage loans, student loans, SME loans, credit card loans etc
- Business receivables which includes Debts owned to businesses, floor rents, equipment leases
How it works
When people take loans from banks or businesses they usually repay the principal
plus interests. The cash flow from this transactions can be very rewarding . Take for instance a mortgage debt of $100,000 at 7% per annum for 20
years will amount to a total repayment of $241,759 accruing a total interest
of about $141,759.21 That is a total of
141% earned on the principal from the lender perspective. A sum of $671.55 will
be received monthly amounting to a total $8058.64 yearly. That is a huge source of steady income.
In the case of an Asset Backed Security(ABS) the bank becomes a intermediary
only and doesn’t use its funds to issue loans but instead uses the investors
funds . A Special Investment Vehicle (SIV) acts as a bridge between the lenders
and the investors by pooling these loans(assets). They are then placed into
categories called tranches according to risk they carry.
The amount of return obtainable from these loans are dependent on the
credit rating of the borrowers (how risky they borrowers are). Those that are likely going to repay back the loan
will the charged lesser interest hence investors receiving these loans will
have lesser returns on their investment. Loans with higher risk of default will
carry higher risk thus high interest rates for both the borrower and the
investor.
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Pros and Cons of investing in Asset
Backed Securities
As with all investments risk is always commensurate with returns however, The following are the likely traits of ABS that may attract you as an investor.
Pros
1. They are fixed
income: The fixed income they provide makes them fall under fixed income
securities which are great if you want to plan your finance over a long period
of time.
2. They diversify risk.
They risk is of a borrower defaulting (failing to repay his or her loan) is
diversified over a large pool hence it is kind of safer
3. Professional assessment:
Before loans are given out the must have undergone several analysis by bankers
and creditors. This aid in reducing the risk of you making a wrong decision as
compared to buying stocks or ETFs.
4. ABS such as Mortgage
Backed Securities(MBS) have an underlying collateral hence should the borrower
default the risk of risking all your capital is negligible as the value of the
underlying collateral is close to the value of the debt.
5. You can find some ABS
listed as an ETF. This allows for more liquidity and allows you to trade them
as you would trade an ETF hence you don’t have to hold them throughout the
period of the underlying debt.
Cons
1. Risky: Loans and
debts especially incurred by individuals generally carry a high amount of risk
when compared to other investments. This Investments was the sole reason the
financial market crashed in 2008. See video here
2. They are not easily
accessible. Only selected financial institutions are allowed to issue these
instruments. Such as investment banks
3. Large Capital
Required:
Summary
Asset Backed Securities, are financial instruments backed by an
underlying debt. Those backed by mortgage are known as Mortgage Backed Securities
(MBS). Investing on a long term perspective is a great way to secure your
future. You can consider trading this securities if the returns of long term
bonds are not that attractive.
Recommended MBS
Some good Mortgage backed securities have been recommended here http://etfdb.com/etfdb-category/mortgage-backed-securities/
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