- This article explains some of the most important financial terms and concepts needed to understand how asset-backed securities work.
- The information is intended for asset managers and investment advisors looking to expand their knowledge and become more well-rounded professionals.
- At FlexFunds, we securitize assets to issue exchange-listed products (ETPs) that can enhance the diversification and liquidity of investment strategies. For more information, feel free to contact our team of experts.
The financial sector includes some highly sophisticated areas that require extensive expertise, such as asset-backed securities (ABS). Understanding this market is crucial, as it reached $389 billion in issuances in 2024 in the United States alone.
Key concepts for understanding asset-backed securities
Now, to understand how these assets operate, it is necessary to become familiar with a series of key concepts:
Asset-backed securities
First, it is essential to define what asset-backed securities (ABS) are, which translate to securities backed by assets.
Since their name is quite explicit, what is crucial to understand is that they take the form of a bond or promissory note, paying interest at a fixed rate over a specified period until maturity based on the cash flows of the underlying assets.
A clear example of an ABS is securities backed by credit card receivables, which were introduced in 1987.
Securitization
Likewise, asset securitization, is the process through which an asset or group of assets is converted into exchange-listed products (ETPs), such as asset-backed securities.
This process is carried out by companies like FlexFunds, which is supported by renowned providers such as Bank of New York, Bloomberg, Morningstar and Interactive Brokers, among others.
Thanks to FlexFunds, both liquid assets (bonds, stocks, currencies) and illiquid assets (real estate, hedge funds, investment funds) can be securitized to enhance the distribution and diversification of investment strategies.
Tranches
Meanwhile, tranches are segments created through a set of securities, such as debt instruments, which are divided based on risk, maturity, and other characteristics.
Also called “portions,” they are divisions of an ABS that are ranked in hierarchies, where the highest have priority for payments, while the lower ones offer higher returns in exchange for greater risk.
Underlying assets
When discussing asset-backed securities, it is impossible not to mention underlying assets, which are simply the assets included, shaping, and generating returns for ABS.
Credit risk
Similarly, the term “credit risk” refers to the probability of default or restructuring of previously agreed payments.
If the issuer of a bond or ABS has a long history of failing to meet its debt obligations, they will generally have a higher credit risk. Conversely, the more reliable the issuer, the lower the risk and, therefore, the lower the return paid to investors.
Diversification
One of the most important terms in the asset-backed securities sector, and in finance in general, is diversification.
This concept involves distributing investment risks across different assets, such as various types of ABS, to reduce exposure to individual threats and, consequently, widespread losses in a portfolio.
âThe logic behind diversification is that by investing in a mix of assets (e.g., bonds, stocks, and ETFs), your portfolio wonât fail if one investment breaks down. Thatâs because different types of assets react differently to turbulences in the market,â explains Goldman Sachs.
Cash flow
Lastly, investment advisors, asset managers, and investors must thoroughly understand what cash flow is.
In simple terms, cash flow is the set of payments that a particular investment, such as asset-backed securities, will make. These payments can be monthly, quarterly, semi-annual, or annual and can be fixed or variable.
Knowing them in advance allows for detecting irregularities in payments and also helps calculate potential earnings for better financial planning.
To learn more about asset securitization and FlexFundsâ ETPs, you can easily contact our team of specialists. We will be happy to assist you!
Sources:
https:/www.sifma.org/resources/research/statistics/us-asset-backed-securities-statistics/
https://privatewealth.goldmansachs.com/us/en/insights/investing-fundamentals-what-is-diversification
