Asset-backed securities (ABS)

Asset-backed securities is a type of investment vehicle in which a pool of income-generating assets, such as loans or debt to issuers, are bundled and converted into a tradable security which are sold to investors.
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Description

Asset-backed securities is a type of investment vehicle in which a pool of income-generating assets, such as loans, are bundled and converted into a tradable security. A company or organisation will sell its loans or debt to an issuer, a financial institution, that then packages the debt into a portfolio to be sold to investors. The process of pooling illiquid assets into tradable financial instruments (securities) is called securitisation. Investors’ returns on the securities are drawn from the cash flow of the underlying assets. ABS can be used to finance or refinance loans to existing assets. ABS are attractive as they provide a steady stream for income-oriented investors, with yield premiums that can be higher than traditional forms of fixed-income instruments, such as government or corporate bonds. In the context of smart city financing, ABS has been primarily issued to finance smaller-scale green or climate smart projects, with loans to green or climate-smart projects as the underlying asset.

Description of Asset-backed securities. Available at: https://corporatefinanceinstitute.com/resources/fixed-income/asset-backed-securities-abs/

Enabling Conditions and Key Considerations

  • Enabling regulatory environment. An enabling regulatory environment that supports the use of ABS is essential. This includes having regulations governing securitisation transactions, investor protection, and disclosure requirements for market transparency. Regulatory certainty is also needed to foster investor interests in ABS.
  • Framework to standardise loan contracts for green or smart city projects. A framework that establishes a systematic approach to categorise and assess loans to green or smart city projects will help ensure that capital raised from ABS are being used to support the transition towards a greener, smarter city. To this end, it is helpful for the public sector to work closely with market players to standardise loan contracts for green or smart city projects.
  • Use of credit-enhancement mechanisms. Use of credit-enhancement mechanisms such as guarantees can improve the credit-rating for the ABS, making it more attractive to investors.

Potential Challenges

  • Complexity of structuring collateral. The underlying collateral in ABS often involves diverse assets. Evaluating and structuring these assets can be challenging due to variations in payment structures, credit quality, and other characteristics.
  • Investor confidence and due diligence. Building investor interest and confidence in the ABS market is crucial. Transparency in the disclosure of information related to the underlying assets, risk factors, and the structure of the securities is important to attract investor interests and maintain market integrity.
  • Sensitivity to market and economic conditions and higher risks. ABS is sensitive to market and economic conditions. Factors such as interest rates, economic downturns, and consumer behaviour can impact the performance of the underlying asset and influence overall structure of the securities. ABS are also subject to more credit, liquidity, and valuation risks than other fixed-income securities.

Potential Benefits

  • Aggregator of small-scale loans. Loans to small-scale projects can be aggregated and securitised to reach an adequate deal size for bond markets. Tagging the securitisations as ‘green’ or ‘sustainable’ allows issuers to tap into increasing demand for securities with environmental benefits.
  • Lower capital cost than bank financing. In high-interest environments, ABS issued in bond markets can be a more cost-effective financing solution than bank financing. This is particularly important for projects that have high capital expenditure.
  • Improves liquidity of illiquid assets. ABS can improve the liquidity of underlying assets by aggregating and converting the various loans into tradable securities. Doing so removes the assets off the balance sheet, and capital raised through the sale of ABS can be used by the loan originators to write more loans and create a new portfolio.
  • Attractive to investors keen on portfolio diversification and yield premium. ABS offers investors a way to diversify their portfolio. By creating tranches of securities from a pool of assets, investors are able to select a risk-reward that best aligns with their risk tolerance. ABS can also offer investors a yield premium compared to more traditional offerings, such as government or corporate bonds, with the same credit ratings. This makes ABS a potentially easier channel to raise funds for smart city projects.

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Case Study

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