In this environment, we believe asset‑backed securities (ABS) can help strengthen a fixed income portfolio by adding diversification while offering the potential for steady income.

ABS are fixed income investments created by pooling income-producing assets and converting them into tradable bonds. Typically, the loans underlying ABS are secured either by physical assets, such as residential or commercial property, or by defined streams of cashflows from consumer or corporate loans.

We believe thoughtfully chosen ABS can complement core bond holdings, and many include built‑in mitigations that cushion against credit stress— supporting more consistent performance across market cycles while letting investors tailor exposure to sectors that match their goals and risk tolerance.<./p>

Here, we outline the key building blocks of ABS: credit quality, attractive yield, improved flexibility and risk management, diversification, and the potential to benefit from the reduced liquidity they typically carry. We also illustrate how everyday payments can be transformed into diversified income.

Robust Credit Quality

ABS may be more resilient in terms of credit risk, due to their unique features: 

• Loans underlying ABS are secured either by physical assets (such as autos, aircraft or equipment) or by defined streams of cashflows (including auto, credit card or student loan payments).

• ABS deals are “bankruptcy remote,” as they are issued via special purpose vehicles (SPV), meaning that their collateral can keep paying out returns even if the original issuer goes bust. 

• Investors benefit from structural protections. These include a reserve, or cash fund, as well as excess spread – i.e., the total interest from the loans exceeds the interest paid out to bondholders, to help cover losses.

• “Tranching” may help to protect some investors. To meet different investor needs, the SPV often issues multiple ABS securities, known as “tranches,” all backed by the same collateral pool, but each with distinct features. This structure allows investors to select tranches that align with their own risk-return objectives. 

Attractive Yield Premium Potential

Since the 2008 global financial crisis, ABS have historically offered higher yields than corporate bonds with similar credit ratings, even in the most straightforward and liquid areas of the market. For example, if we compare spread over risk-free rates of a portfolio of global ABS to that of A-rated corporate bonds, we see ABS offer a significant premium. 

There are several factors which explain this premium, including regulatory considerations, complexity and negative investor sentiment (from the legacy of the 2008 crisis) as factors which reduce demand, in our view, and thereby underpin the existence of a yield premium in ABS.

This yield advantage is significant: AAA-rated ABS now provide only slightly lower spreads than A or BBB-rated corporate bonds of the same maturity. Additionally, while there are very few AAA-rated corporate bonds outstanding, AAA ABS securities are widely available. Therefore, for investors seeking higher-rated investments, ABS can present an appealing alternative. Likewise, for those comfortable with the risk level of A-or BBB-rated bonds, ABS may offer an opportunity to potentially earn a higher credit spread. 

Improved Flexibility and Risk Management

Short-dated ABS historically offer lower interest-rate sensitivity, a faster return of principal, and more predictable cash flows which can improve flexibility and risk management. Their shorter maturities also limit exposure to shifting economic conditions.

Market volatility is typically lower as a result, with spread-widening environments constrained by shorter maturity dates, leading to a quicker recovery period as the bonds’ prices typically gravitate to the prices they will be repaid at (known as par), generally occurring more rapidly than in the broader corporate bond universe. The asset class can therefore be an effective complement to a corporate bond portfolio with longer spread duration.

Increased Diversification

Securitized products can offer several diversification benefits within a fixed income portfolio. A corporate bond is rated based on debt coverage/ cashflow coverage levels, with interest and principal paid out of general corporate cashflows. Ratings are therefore exposed to industry fundamentals, management decision-making, and other specific factors.

On the other hand, asset-based instruments are secured on and repaid by the cashflows that derive from specific assets. Those assets can be highly diverse and can include residential mortgages, car loans, and commercial real estate loans as well as more “esoteric” assets, like data center leases, fiber infrastructure, music or streaming rights, and peer-to-peer consumer loans.

ABS can offer exposure to the consumer or broader macroeconomic trends, whereas traditional corporate bonds are heavily exposed to corporate management teams. 

Securitized assets can also be highly granular with hundreds or even thousands of different individual borrowers backing an individual transaction. This can offer significant diversification. For example, if a bank goes into default, holders of its equities or corporate bonds may face losses. But for an ABS originated by that same bank, the credit risk is to the underlying borrowers, not the originating bank.

ABS markets are sizeable and offer a wide range of opportunities, including agencies, residential mortgage-backed securities (RMBS) and collateralized loan obligations (CLOs). Our estimates of total U.S. investable markets are shown in the table below.

Potential for Illiquidity Premium

The inclusion of less liquid ABS, in the form of asset-based finance, can introduce further benefits to a fixed income portfolio, such as:

• An enhanced potential for returns
• Self-liquidating features through amortization, prepayments, and regular hard maturities
• More control in the structuring of instruments, which can deliver lower default probabilities and higher recovery estimates than equivalent public instruments
• An increased diversification of asset types
• The potential for more targeted positive impacts by focusing on specific investment sectors or through the creation of certain structural features

The chart below illustrates the enhanced potential for returns from incorporating less liquid ABS by showing the spread of a combined portfolio of ABS and asset-based finance against comparable corporate bonds.

Appendix

¹Chart page 2: Global ABS are represented by a representative portfolio of global ABS. USD is represented by the ICE BofA U.S. Corporate Bond 1-5 year Index. EUR corporates are represented by the ICE BofA Euro Corporate 1-5 year Index. Spread is shown as spread over swaps (corporate bonds) or over a risk-free rate (Global ABS). Bp represents basis points.

²Chart page 4: Combined ABS are represented by a representative portfolio of ABS and less liquid asset-based finance assets. EUR corporates are represented by the ICE BofA Euro Corporate 1-5 year Index. USD is represented by the ICE BofA U.S. Corporate Bond 1-5 year Index. Spread is shown as spread over swaps (corporate bonds) or over a risk-free rate (Combined ABS). Bp represents basis points.