As an investor, you probably own mutual funds and have an understanding of how they work. However, you may not have considered how the vast majority of other investments work or how they integrate into various investment portfolios. In this article, we will look at Asset Backed Securities and the function of Securitization

Asset Back Securities (ABS) and Securitization goes on around us all the time, we just do not really see it first hand, unless of course you work in a large financial institution or the Treasury Department of a large multinational company.

First, let's define Asset Back Securities (ABS):
Let's be clear, the word 'Securities' in this phrase has nothing to do with a uniformed gentleman patrolling the courtyard or car park of an apartment complex or office building to keep away thieves! In this context, Securities are financial products / instruments that people and institutions invest in with the hopes of making a financial gain. The easiest example of Securities is stocks e.g. Volkswagen, IBM, Apple etc... people buy these Securities (stocks) with the hope that the stock price increases and their investment portfolio has positive performance. Bonds are also Securities. People usually buy Bonds in order to generate income for their portfolio. One can also trade Bonds in order to make a financial gain. Thus, Asset Backed Securities, also called ABS for short, are Securities that people / institutions usually invest in to generate income for their portfolio. In fact, Asset Backed Securities are just like Bonds. The income that one receives from ABS is supported (collateralized) by some type of financial asset (receivable / payment), hence the term 'asset backed'. A portfolio that is designed with a stock and bond mix may contain ABS in the bond allocation segment. This may well be achieved through "bond style" mutual funds or by investing with money managers that focus on various debt style offerings that generate income.



So what are the actual assets that support these ABS financial products? Well, it varies throughout the world and with the industry / company that is issuing / sponsoring them. The easiest example is when one buys ABS that are supported by mortgages i.e. mortgage payments / receivables. The assets that back these securities are actual mortgage payments. Think of it like this: When a Bank lends you money to purchase a house, the Bank is taking a risk, but is also generating income for the bank (the interest you are paying on the mortgage is how the bank makes money - the receivable). However, at some point, the Bank has loaned money for thousands of different home purchases for thousands of different people, businesses and families, all of them taking out a mortgage. The Bank has essentially taken on an enormous amount of risk, and cannot really lend any more money... until they "Securitize" (package up these mortgages into tradable financial products called ABSs) and sell them off to investors. The mortgages / loans are pooled together, sold to a Special Purpose Vehicle (an SPV is just an entity really, a bit like an LLC), then the SPV sells the pool to a Trust (another entity), to repackage them again, as income style investments. The Trust usually includes some form of credit enhancement to the pool form a third party to help guarantee payments to the investors. The credit rating of the ABS may end up being better than that of the original Bank (issuer / sponsor). The SPV exists really to isolate the risk. As you may expect, when this process is complete, these ABSs are commonly known as Mortgage Backed Securities. If you feel this ties into the 2008 financial crisis, then you are getting to grips with this subject fast.

When Securitization is done, the Bank can then start lending more money again and start making more profits. It has freed up some capital and removed some risk from its balance sheet. Banks have a certain reserve requirements and if they get close to this threshold, it would be hard to keep lending money. Hence, Securitization happens almost on a daily basis, henceforth keeping the lending ability of the bank (the sponsor / issuer) fluid. Investment banks play a part in this when they actually underwrite the ABSs.
Auto manufacturers like Porsche, Volkswagen, Ford, Audi, etc... are common issuers / sponsors of Asset Backed Securities. However, instead of mortgages that back the Security, it is car loans and car leases. The reason that companies like Porsche "Securitize" these loans and leases into ABS products is the same reason that the banks do it: To reduce risks and free up more capital and thus improve the balance sheet of the company so that they can go on to do more leases / car loans and make more money. A good looking balance sheet may have a positive effect on the stock price of the company issuing the ABS. If this looks like a cycle, then you are right, because it is!
Credit card receivables, home equity loans and airplane leases are all common income generating ABSs too. As the name implies, airplane leases are issued with respect to the planes that are being leased by large airlines from firms like Boeing or AirBus. Boeing or Airbus has a receivable coming in the door on a regular basis, so they move the financial liability off the balance sheet by going through the process of securitization.

Trading ABS


Sunguard's Front Arena and MarketAxess are both leaders in electronic trading for the institutional corporate bond market and now offer a dynamic multi-dealer electronic trading platform for consumer-based asset-backed securities (ABS). Beginning with a focus on the most liquid, highest quality ABS issues, MarketAxess has introduced to the ABS market the benefits of greater efficiency delivered on a patented MarketAxess request-for-quote (RFQ) platform.

ABS Trading Platform Highlights include:
  • Consumer ABS product types: credit cards, autos, student loans, equipment leases, floor-plans, timeshares, etc.
  • Patented bid/offer list trading functionality helps efficiently manage daily cash-flow and sector rotation trades
  • Bid/offer list functionality for up to 40 simultaneous line items
  • Standard timers create a dynamic and fair auction process
  • Spread pricing protocols for uniform dealer responses on bid and offer requests
  • Competitive responses via simultaneous access to multiple dealers
  • Straight-through-processing for increased speed and efficiency
  • Business intelligence reporting

Discussions with market participants show that compared to Treasury securities and mortgage-backed securities, many asset-backed securities are not liquid, and their prices are not transparent. This is partly because asset-backed securities are not as standardized as Treasury securities, or even mortgage-backed securities, and investors have to evaluate the different structures, maturity profiles, credit enhancements, and other features of an asset-backed security before trading it.
The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap rate. For example, the price of a credit card-backed, AAA rated security with a two-year maturity by a benchmark issuer might be quoted at 5 basis points (or less) to the two-year swap rate. 

Summary
So we see that ABS and Securitization is all about moving risk off the balance sheet, making the company look appealing to shareholders, and helping investors generate income for their portfolios. As with all types of securities, there are risks involved in trading where you can lose money if the ABS does not 'perform' as expected. Some are riskier than others. Trading ABS is feasible, but it is most definitely geared more towards licensed securities professionals, treasury departments, advisors and hedge fund managers.

1) Investment Company Institute, 2012
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. 

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Despite the pick-up in volatility at the end of January, risk assets continued their upward ascent throughout the month. Expectations surrounding the implementation of the newly passed tax reform bill and the weakening US dollar served as positive catalysts for the month. Macroeconomic data was mixed; fourth quarter real GDP growth came in slightly below expectations but manufacturing activity accelerated and the US jobs report was positive. Although we have seen initial signs of rising inflation, levels remain subdued as low unemployment has yet to translate into meaningful wage growth. We expect the Federal Reserve (Fed) to remain on track with interest rate normalization and the positive, albeit choppy, market momentum we have seen to date indicates that markets can likely withstand an additional Fed rate hike in March.
The S&P 500 Index was up 5.7% for the month with cyclicals outperforming defensive sectors. Consumer discretionary (+9.3%) led while tax cuts and a solid job market served as positive catalysts. Information technology (+7.6%) and financials (+6.5%) also posted strong returns for the month. Utilities (-3.1%) and REITs (-2.0%) were down as traditional bond proxy sectors experienced headwinds amidst rising interest rates. Growth outperformed value and large-cap outperformed both mid-cap and small-cap equities.
Developed international equities (+5.0%) performed in line with domestic equities. Fundamentals within the Eurozone continued to improve and sentiment is high. The focus remains on European Central Bank policy and how the reduction of its quantitative easing purchases will impact markets. Emerging markets were up 8.3%. A weaker dollar and stronger demand for commodities served as tailwinds for both emerging Asia and Latin America regions.
Feb. 2018 Market Outlook
The Bloomberg Barclays US Aggregate Index was down -1.2% for the month. Interest rates surged with 10-year Treasury yields increasing 31 basis points, ending the month at 2.7%. Tightening monetary policy and improving US growth expectations will likely continue to put upward pressure on the long end of the yield curve. High yield was the only sector to post positive returns in January, as credit spreads continued to grind tighter. Like taxable bonds, municipals were negative for the month.
We remain positive on risk assets over the intermediate-term, although we acknowledge we are in the later innings of the bull market and the second half of the business cycle. While this cycle has been longer in duration compared to history, the recovery we have experienced has been muted, supported by the extended recovery period. While our macro outlook is biased in favor of the positives, the risks must not be ignored.
We find a number of factors supportive of the economy and markets over the near-term.
  • Pro-growth policies of the Administration: The Trump administration has delivered a new tax plan and a more benign regulatory environment. We could see additional government spending on infrastructure in 2018.
  • Synchronized global economic growth: Growth in the US has started to accelerate, and growth in both developed international and emerging economies has meaningfully improved. The tax cuts could also help to boost GDP growth in 2018.
  • Improvement in earnings growth: Corporate earnings growth has improved globally and corporate tax reform should further benefit US-based companies.
  • Elevated business sentiment: Measures like CEO Confidence and NFIB Small Business Optimism are at elevated levels. This typically leads to additional project spending and hiring, which should boost growth. The corporate tax cut should also benefit business confidence and lead to increased capital spending.
However, risks facing the economy and markets remain, including:
  • Fed tightening: The Fed will continue to tighten monetary policy, with at least three interest rate hikes priced in for 2018. We may see tightening from other global central banks as well.
  • Higher inflation: Current levels of inflation are muted but inflation expectations have ticked higher and the reflationary policies of the Administration could further boost levels. Should inflation move higher, the Fed may shift to a more aggressive tightening stance.
  • Geopolitical risks: Geopolitical risks including trade policies and global challenges could cause short-term market volatility.
Despite the volatility experienced over the last week, the technical backdrop of the market remains favorable, credit conditions are supportive, and global economic growth is accelerating. So far President Trump’s policies are being seen as pro-growth, and business and consumer confidence are elevated. The onset of new policies under the Trump administration and actions of central banks may lead to higher volatility, but our view on risk asMarchsets remains positive over the intermediate-term. Higher volatility can lead to attractive pockets of opportunity we can take advantage of as active managers.
Brinker Capital Barometer (as of 1/5/18)
Brinker_Barometer_1-5-18


Source: Brinker Capital. Leigh Lowman, CFA, Investment Manager. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. Indices are unmanaged and an investor cannot invest directly in an index. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. S&P 500: An index consisting of 500 stocks chosen for market size, liquidity, and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of US equities and is meant to reflect the risk/return characteristics of the large-cap universe. Companies included in the Index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor’s. Bloomberg Barclays US Aggregate: A market capitalization-weighted index, maintained by Bloomberg Barclays, and is often used to represent investment grade bonds being traded in United States.
Views expressed are those of Brinker Capital, Inc. and are for informational/educational purposes.  Opinions and research referring to future actions or events, such as the future financial performance of certain asset classes, indexes or market segments, are based on the current expectations and projections about future events provided by various sources, including Brinker Capital’s Investment Management Group. Information contained within may be subject to change. Diversification does not assure a profit not guarantee against a loss.
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Hedges Wealth Management.
 
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