Building a successful bond portfolio is all about balancing risk with reward/yield. And right now, that task is becoming difficult. Thanks to increasing volatility, tight credit spreads, shocks to global trade and the economy, and persistent inflation, building a successful fixed-income portfolio is no easy feat. But there may be one asset class that makes the job easier, all while providing low correlation and a high yield.
We’re talking about asset-backed finance (ABF).
Despite being one of the largest segments of the bond market, ABF bonds or asset-backed securities (ABS) are mostly ignored by investors. This is a real shame as they offer a way for investors to score a high yield while bypassing some of the current risks in the fixed income world. Better still, the number of opportunities within the ABF world is only growing.
What Is ABF?
At their core, bonds are IOUs. Whether it’s federal Treasury notes or high-yielding junk debt issued by a tech start-up, you’re lending someone money when you buy a bond. ABS are also loans. The difference is that these are pools of loans backed by an actual asset.
This happens through a process known as securitization. Securitization takes pools of loans and other illiquid debt and packages them together, creating a new security that is then sold to investors. 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.
These pools of loans can be anything, but the most popular types are pools of credit card receivables, auto loans, including recreational vehicles, home equity loans, student loans, loans for boats, and capital equipment loans. Mortgage-backed securities are also considered ABS bonds. However, given that much of the market is dominated by government-sponsored entities and backing, MBS bonds often get placed in their category by investors and have a different set of fundamentals than, say, a pool of solar power purchase-agreement-backed loans.
An ABS investor makes money when a consumer or business makes a payment on their loan, and the cash flows into the ABS bond. The bond “collects” the payments through its various loans, and then “passes through” this cash to the owners of the ABS. These payments typically include both interest and principal. This is different from a Treasury bond, in which Uncle Sam pays interest and then principal back at maturity.
Why Bother With ABS?
For many investors, the question is, why bother with ABS bonds? After all, a pool of credit card receivables seems pretty risky, particularly when cash is paying 4%. The thing is, ABF bond pools may have less risk than some investment-grade sectors.
As you can see from this chart from Janus Henderson, ABS bonds have a higher average credit rating than investment-grade corporate bonds. To put it another way, there are more AAA- and AA-rated asset-backed securities than there are corporate bonds with similar ratings.
Source: Janus
That high credit rating comes from “asset-backed” in their name. Typically, the underlying assets of ABS are collateralized with a moderate loan-to-value ratio. That means a debtor needs to put up more capital for the asset rather than take out debt. Secondly, because there is a physical good attached to the loan, in the case of default, the creditor can go after the asset. This leads to higher recovery rates vs. many other bond asset classes. Additionally, ABS bonds tend to have different tranches, so investors can tailor their risk tolerance, ensuring that those willing to take on more credit risk can earn higher returns.
Despite being the lower-risk option vs. corporate bonds, asset-backed bonds tend to pay slightly more in yield than their IG twins. Investors can pick up a few extra basis points in the sector. Better still, ABS bonds tend to have lower duration risk, as many bonds within the sector are floating rate and have yields that shift with regard to changes to interest rate policy.
The final reason why asset-backed finance makes sense for a portfolio comes down to correlation. Investors tend to paint bonds with a wide stroke, but each type is very nuanced. According to Janus, securitized assets and indices generally exhibit lower correlation to equities than corporates. In this case, less than 0.3% versus the S&P 500. That’s versus a 0.8% for high-yield bonds and 0.6% for IG corporates over the last decade. Investors can get a high yield and actual diversification from a bond sector by choosing ABS. 1
The Opportunity Today
Asset-backed bonds offer a lot for portfolios, and investors have perhaps ignored them outside the world of mortgage-backed securities. Less than 1% of broad fixed-income indices like the Agg have exposure to ABS bonds outside of mortgage-backed securities.
But that could be changing.
For starters, thanks to new regulatory capital relief rules that allow banks to securitize and hold more of their less risky loans as ABS bonds, the number of opportunities in the sector is growing. At the same time, private credit is now getting into the act, with asset-backed finance quickly becoming a strong growth engine. This has created more opportunities for investors within the sector.
Additionally, those opportunities have come with some of the largest spreads (i.e., additional yield over corporates and Treasuries) in quite some time. So, today, investors have even more ABS bonds to choose from, at lower risks and higher yields. All of this provides additional alpha for fixed-income portfolios.
Perhaps the best part is that getting your hands on ABS bonds has never been easier. The ETF revolution has created new funds that dabble in these bonds across a wide set of different securitized asset classes.
ABS ETFs
These ETFs were selected based on their ability to provide exposure to the ABS market. They are sorted by the YTD total return, which ranges from -0.2% to 2.6%. They have expense ratios between 0.03% and 0.53% and assets under management between $294M and $38B. They are currently yielding between 3.7% and 9.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| GNMA | iShares GNMA Bond ETF | $357M | 2.6% | 4.3% | 0.11% | ETF | No |
| MBB | iShares MBS ETF | $37.6B | 2.5% | 4.2% | 0.05% | ETF | No |
| VMBS | Vanguard Mortgage-Backed Securities ETF | $21.7B | 2.4% | 5.2% | 0.03% | ETF | No |
| SPMB | SPDR Portfolio Mortgage Backed Bond ETF | $5.9B | 2.4% | 3.73% | 0.05% | ETF | No |
| JMBS | Janus Henderson Mortgage-Backed Securities ETF | $5B | 2.4% | 5.1% | 0.26% | ETF | Yes |
| JSI | Janus Henderson Securitized Income ETF | $673M | 2.1% | 5.8% | 0.53% | ETF | Yes |
| CLOI | VanEck CLO ETF | $955M | 1.7% | 5.4% | 0.40% | ETF | Yes |
| PAAA | PGIM AAA CLO ETF | $2.7B | 1.6% | 5.3% | 0.19% | ETF | Yes |
| CLOA | iShares AAA CLO Active ETF | $294M | 1.6% | 5.5% | 0.20% | ETF | Yes |
| JAAA | Janus Henderson AAA CLO ETF | $21.9B | 1.4% | 5.8% | 0.22% | ETF | Yes |
| JBBB | Janus Henderson B-BBB CLO ETF | $2.03B | -0.2% | 9.5% | 0.50% | ETF | Yes |
Overall, the asset-backed bond market is a wonderful place for investors to find strong yields and high credit quality. And yet, it’s ignored by many portfolios aside from a tiny sliver. That’s a real shame, as the asset class has a lot to offer. Now, with growth at hand, the sector could be even better. For investors, that means giving ABS bonds a dedicated place in our fixed-income allocations.
Bottom Line
Asset-backed finance (ABS) and securitized bonds offer a unique, lower-risk opportunity within the fixed-income world. But many investors ignore the opportunity. With growth assured and yields high, the time to add the sector could be now.
1 Janus (February 2025). Busting the bias against U.S. Securitized
