Trading Asset-Backed Securities
Asset-backed securities are investment tools that are similar to corporate bonds except that they are packaged by a pool of debt. A fund that specifically invests in bonds and other forms of debt is called a bond fund. A bond fund is usually compared to a mortgage bond except that the bond fund debt is not related to mortgage. A mortgage bond is a debt security that uses a mortgage as the underlying asset.
Unlike corporate bonds, three groups are involved in asset-backed and mortgage-backed securities. The seller is the company that originally extended the loan. In order to get the loan off its balance sheets, the seller will sell the loan payments to an issuer who will service them and package them as investments for investors. Because these types of securities are based on loan repayments, there is a default risk as well as a risk of early repayment. If the loan is paid back early, then less interest is paid.
Asset-backed securities use loan assets that are not mortgages. Examples of these loan assets include auto loans and credit card debts. They are pooled together and sold in denominations of $1,000 on the over-the-counter (OTC) market. This is a secondary market in which buyers bid for a unit of the security. Most of the investors in asset-backed securities are large institutional investors that trade over $1 million in securities at a time. Credit card and auto loan asset-backed securities are considered investment grade and constitute the greatest portion of the asset-backed securities trades. Because they carry greater risk than corporate bonds, they generally have a higher yield. Other types of asset-backed securities that use riskier debts give even higher yields and are similar to junk bonds in yield and risk.Asset-backed securities are bundled into tranches, or portions of debt or securities that divide risk in order to be marketable to different investors, labeled A, B, and C. Investment-grade tranche A has the largest pool of securities with the best credit. Tranche C, often considered unrated, has the lowest grade, smaller pools, and lower credit. A pool of loans that are held by people with great credit would have an asset-backed security rating of AAA.
How Loans Pool to Become Investments
Types of Asset-Backed Securities
Whether securities are mortgage backed or asset backed, they will have an original issuer. These issuers can be private companies, like banks that offer loans. Alternatively, they can be government agencies, such as the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), or the Federal Home Loan Mortgage Corporation (Freddie Mac). Because government asset-backed securities are sponsored by the government, they carry a negligible risk and are considered risk-free when it comes to default. And because government-backed securities are generally mortgage based, the borrowers of the loans have met a standard at which the government is willing to guarantee the loans. A bond rating agency will give these securities a higher credit rating than private asset-backed securities. A bond rating agency is an independent organization that analyzes bonds and the underlying assets in order to offer an investment rating. This makes government-backed securities investment grade, meaning that they have ratings of Baa or higher and meet financial institution investment standards.
Conversely, borrowers of loans from private lenders often cannot qualify for government loans; there is, therefore, a greater risk of default with a private loan. Banks will not guarantee the loan for the security, so the risk of default is passed to the investor. The risk is even higher if the loan is subprime, indicating a higher likelihood that the borrower will not meet their debt obligations.
Many private or nonagency asset-backed securities are not investment grade but offer high yields. Private asset-backed securities are linked to the economy at large. A poor credit market gets subsidized as an investment tool. This means lenders allow for loans to borrowers who have even lower credit. In the early 2000s, this cycle created predatory lending practices and was a substantial factor in the housing crisis. Because of this, private asset-backed securities have become less frequently traded.
Risks of Asset-Backed Securities
Asset-backed securities are pools of debt. This pool can be structured to mitigate default risk. For example, if a pool is composed of only subprime, poor-credit loans, then the overall pool has a higher risk of default. Conversely, a pool of only good-credit borrowers would have a low risk of default but, with the low risk, would have a lower return. Asset-backed securities issuers will try to structure the pool with a blend of loans of differing default risks to get the highest return and still maintain investment-grade status. If Megacompany Inc. is a lender with 90 loans, it may choose to pool its top 30 highest-credit loans and create an AAA security and then take its next 30 and create a BBB security, leaving its bottom for a C-rated security. Conversely, it may blend its securities so that one pool has a mix of good, moderate, and poor credit loans, giving three BBB-rated securities.
The backing for an asset-backed security comes from the interest but not the principal being paid on a loan. If one of the loans in the pool were for $100,000 with 10 percent annual interest, the investors would proportionally divide $10,000 from the interest but not any of the payment that was applied to the principal. The security pool would assume that the loan will be paid off over the entire term of the loan. When interest rates drop, it is common for borrowers to refinance the loan, which will take it out of the securities pool, decreasing the earnings of the investor. This is a prepayment risk.
Like prepayment risk, reinvestment risk is associated with interest rates. Reinvestment risk is the likelihood that an investor won't be able to reinvest at a rate comparable to the current investment's current rate of return. If a loan in a pool is paying 10 percent interest and the interest rate goes down, a borrower may refinance, or renegotiate the interest rate, payment schedule, and terms of a previous credit agreement, and the loan may stay in the pool. If the new interest rate is 7 percent, then the investment has decreased by 3 percent for this loan component. The reinvestment risk is a major concern for institutional investors such as insurance companies that count on a steady, predictable flow of funds from their investments.