Asset-Backed Security (ABS)

Like mortgage-backed securities, ABS are created through securitization. A lender sells a pool of loans to a separate entity, which issues securities to investors. Payments from borrowers on the underlying loans are used to pay interest and principal to the investors.

For example, a car finance company might pool thousands of car loans and issue ABS backed by them. Investors receive payments as car buyers repay their loans, and the finance company receives cash to make more loans.

ABS are often divided into tranches. Senior tranches are paid first and carry lower risk and lower yields, while junior tranches absorb losses first and offer higher yields. Additional protections, such as extra collateral or reserve accounts, may be added to improve the credit quality of senior tranches.

ABS allow lenders to raise funds and transfer risk, and give investors access to diversified pools of consumer and business loans. Their risk depends on the quality of the underlying loans, the structure of the deal and economic conditions. In a recession, rising defaults on the underlying loans can lead to losses for investors, especially in the junior tranches.