What is an Asset-Backed Security?

An asset-backed security is a debt instrument that makes coupon payments with cash flows generated from specific assets.  Asset-backed securities became very popular in the 1980s when fixed income traders observed the tremendous size of residential mortgage portfolios held by domestic savings and loan institutions. Traders realized the principal and interest payments made by millions of home owners could be pooled together and securitized as a fixed-income product (Reference the tutorial, Mortgage-Backed Securities). Subsequent to the development of mortgage-backed securities, traders began to structure asset-backed securities such as Certificates of Automobile Receivables (CARS) and others using the cash flows generated from credit card notes, student loans, etc.

Corporations can benefit from issuing asset-backed debt for two reasons. First, if a corporation defaults on its asset-backed debt, creditors can generally only turn to the pledged assets to recover their investment. The second benefit relates to the fact that credit rating agencies rate asset-backed debt by the quality of the securitized assets, not the issuer. By structuring debt that is secured by relatively liquid assets, such as receivables, a company with a poor credit rating can obtain a higher credit rating for the issue, lowering their cost of debt.

Questions:

1. What is an asset-backed security?

2. How can corporations benefit from issuing asset-backed securities?

Answers:

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