Asset-backed Bonds (ABS) – Good Choice or High-Risk Time Bomb?

Securitization is a modern process, first created in the 1970s with mortgages, they took off in the mid-1980s. The concept is simple: Securitization takes pools of loans and other illiquid debt and packages them together, creating a new security which is then sold to investors. The idea is that the new securitized bond removes the loan/debt from the lending institution’s balance sheet, eliminates risk and provides new capital for the bank/lending institution to make more loans.

It’s here that the humble asset-backed security (ABS) is born.

As the name implies, ABS bonds are backed by some variety of assets. In this case, most ABS bonds are pools of credit card receivables, auto loans (including recreational vehicles), home equity loans, student loans, loans for boats and capital equipment loans. Technically, mortgage-backed securities are also considered ABS bonds, but they get placed into their own category by investors.

When a consumer or business makes a payment of interest and principal on their loan, the cash flows into the ABS bond and “passes through” to the owners of the ABS. This generates income for bond holders.

For investors, ABS bonds offer some unique wins for their portfolios. For one thing, they often provide higher yields. Given the default risks, a typical ABS bond will pay more than safer Treasuries for the same duration/time profile. With that, investors can boost the yield of their portfolios.

Secondly, ABS bonds allow investors to own some esoteric and illiquid asset classes. Pools of credit card receivables and RV loans fall outside the norm of regular bonds like Treasuries and corporate debt. By buying an ABS bond, investors can gain some non-correlated fixed income exposure. And they can do so with plenty of diversification. The average ABS bond holds hundreds of loans and debts, providing a diversified source of cash flow.

Finally, ABS bonds can feature different credit and risk profiles. When creating an asset-backed security, the creator – called a special purpose vehicle (SPV) – will often pool the assets in the ABS into different credit ratings/risk profiles. These are called tranches. As cash flows from the assets into the ABS, the SPV will funnel that cash into the various tranches, paying the top levels first. So, investors can tune their risk profiles/yield needs accordingly.

So, with an ABS bond, investors can get access to illiquid asset classes and high yields. But to do so, ABS bonds come with some big risks. The biggest ones are default risks and economic sensitivity.

Asset pools like credit card receivables, airplane and auto loans aren’t exactly risk free. The pooling of these various loans reduces risks:- If one person stops paying their car loan, the other 100 people keep the cash flowing. But defaults do happen and there have been numerous times in history when entire swaths of the ABS market have defaulted and had issues. For example, during the Great Recession, numerous ABS bonds tied to everything from credit cards and home equity loans defaulted, becoming toxic assets and having their cash flow dwindle to zero. More recently we’ve seen the rise and fall of residential solar-backed bonds. Today, many fintech “buy now, pay later” ABS bonds are starting to show cracks.

All in all, ABS bonds work very well … until they don’t. When recession risks run high and the economy becomes a little dicey – like today – investors could be on the hook. This explains why ABS yields are currently at highs not seen in about a decade.

Given the higher risks yet higher rewards, ABS bonds could find a home in your portfolio. Buying them individually is pretty much a no-go unless you are a high-net-worth investor or a major client at an investment bank. That means the rest of us need to use funds to purchase them.

Many broad bond index funds have some exposure to ABS bonds; albeit, usually less than 1%. ABS bonds are also a favorite stomping grounds of many actively managed total return bond funds. You may already have some exposure in your portfolio.

Investors willing to take on the additional risk and make ABS bonds a sleeve of their portfolio have some specific choices. For example, the BlackRock AAA CLO ETF (CLOA), Virtus Newfleet ABS/MBS ETF (VABS) and Panagram BBB-B CLO ETF (CLOZ) offer direct exposure to asset-backed securities, while the Loomis Sayles Securitized Asset Fund (LSSAX) uses a mutual fund to get access.

Adding a swath of these funds could be key to getting some additional yield into a portfolio. However, investors need to understand the risks and keep the positions small.

In the end, asset-backed securities provide an interesting fixed income asset class for portfolios. While there are risks, investors do get higher yields. For more aggressive investors, ABS could be top-notch play.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.