An asset-backed security is a type of bond or note that is based on a pool of assets, or collateralized by the cash flows from a specified pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. Securitization makes these assets available for investment to a broader set of investors. These asset pools can be made of any type of receivable, like credit card payments, auto loans, and mortgages. Typically, the securitized assets might be highly illiquid and private in nature.
The underlying assets in an asset-backed security can be either an amortizing or a non-amortizing asset. While in amortizing assets, the loan repayment is distributed over the life of the loan, non-amortizing assets do not have a particular fixed pattern of payment of interest and repayment of principal.
Asset-backed securities can be classified as fixed and floating rate asset-backed securities. A floating rate asset-backed security is one whose underlying pool consists of loans or receivables carrying a floating rate. In fixed rate asset-backed securities, the underlying pool consists of fixed-rate loans whereas in a floating rate loan, the security is divided into one or more floating rate tranches.
Credit enhancement encompasses a variety of provisions that may be used to reduce the credit risk of an obligation. It refers to one or more initiatives the originator in a securitization structure has to enhance the security, credit or the rating of the securitized instrument, i.e., by providing a cash collateral, profit retention, third party guarantee, etc.
An asset-backed security can either have a pass-through or a pay-through structure. In a pass-through structure, each certificate holder will be allotted a proportion of the cash flow from the underlying pool of loans or receivables on a pro rata basis. In a pay-through structure, while a senior tranche can be split into different tranches, a subordinated tranche cannot be done so.