The ABCs of Asset-Backed Finance

Summary

Asset-Backed Finance (ABF) refers to the broad spectrum of lending instruments secured by contractual cashflows and related assets. ABF investing spans the debt and equity capital markets, with investment opportunities populating a continuum of liquid and illiquid formats, in bond and loan form, across public and private markets.

Historically, borrowers seeking asset-backed financing have turned to banks. While banks remain important players, post-Global Financial Crisis (GFC) regulations made this business less profitable for them and led many to scale back. In their place, non-bank lenders—including investment funds, life insurance companies, and high net worth individuals, often enabled by new technology—have opportunistically stepped in to supply capital to the large, diverse, and growing ecosystem of asset-backed finance.

Asset-backed finance has taken on many names over the years. Structured credit and securitization finance are alternative descriptions of large swathes of the ABF market, while collateralized loan obligations (CLOs), asset-backed securities (ABS), and residential mortgage backed securities (RMBS) are subsectors of the market. The many variants of ABF all describe investments born of the same process: pooling similar assets, tailoring a financing solution to suit the assets, and then issuing bonds or loans through which different investors fund the assets.

Asset-backed finance (ABF) instruments differ from corporate credit in that they are secured primarily by the contractual cashflows of specific assets, with ownership rights serving as secondary collateral. Estimates of the size of the ABF market vary greatly—we estimate the ABF market as approximately $25 trillion, with non-government tradeable securities representing just over $3 trillion. The ABF market is large, non-standardized, and non-indexed, spanning diverse asset classes from aircraft leases and residential mortgages to data centers and royalty agreements. Our success in this market reflects both the depth of our experienced teams—across origination, credit, risk, trading, legal, and technology—and our disciplined investment process. Our approach is designed to strip away bias, direct capital to the most attractive subsectors, and limit exposure to the risk bubbles that periodically form in underlying asset markets.

Report Highlights

• Asset-backed finance refers to the broad spectrum of lending instruments secured by contractual cashflows and related assets. Each asset features a payer (borrower, lessee, insurer, etc.) and a contract (mortgage, lease, loan, account receivable, etc.). A securitization typically pools contractual assets of the same type (auto loans, aircraft leases, credit card receivables, corporate loans, etc.).
• ABF deals carry investor-friendly features intended to help protect against loss and improve liquidity, including bankruptcy remoteness, prioritization of payments, overcollateralization, excess spread, amortization, professional servicing, and diversity of payers within each underlying pool.
• Lenders, lessors, and specialty finance companies commonly turn to the ABF market for funding. Additionally, traditional corporate borrowers that receive payments under contracts may securitize those contracts as an alternative to issuing corporate debt, particularly when the contracts are of higher credit quality. We illustrate such a situation with a case study on page 12.
• ABF transactions are created through a process called securitization. Securitization begins with the creation of a special purpose vehicle (SPV) that acquires a pool of assets and simultaneously raises debt financing through the issuance of secured loans or ABS Notes to fund the purchase of those assets.
• Within the broader ABF market is a tradeable, bond-form $3.3 trillion structured credit market comprised of $1.7 trillion residential and commercial mortgage-backed securities (RMBS and CMBS) markets, and the less well-followed $1.6 trillion non-real estate ABS market.
• Successful investment in ABF requires dedicated credit, trading, technology, legal resources, institutional knowledge, and a disciplined investment process.

Introduction to Asset-Backed Finance

Securitization, structured products, structured credit, and ABF almost always refer to the same investment category: interest-bearing debt—i.e., bonds, loans, or similar instruments—secured primarily by pools of contractual obligations to pay.

Too often, we find that reports on structured credit or ABF as an asset class rely on jargon, anecdotes, inaccurate definitions, and generalizations. Our goal is to provide a coherent description that answers the following fundamental questions: Why does securitization, the process that creates structured credit investments like public ABS bonds or private ABF bilateral transactions, exist? How does structured credit differ from traditional corporate credit, mortgage lending, or leasing? What distinguishes a “securitizable” asset from other assets such as real estate, guarantees, or equity interests? How are common features of structured credit intended to help protect debt investors? What roles do originators and servicers play? What are the benefits to the borrower?

Structured credit instruments are complex investments and are not suitable for all investors because they are subject to many risks, including credit, liquidity, interest rate, and valuation risk. We present this primer with the hope that investors can approach the sector with greater familiarity and perspective.

The Elephant in the Room

During the GFC, many investors experienced losses related to private label RMBS, CMBS, and MBS-backed collateralized debt obligations (CDOs). This dislocation exposed investors who based their investment decisions primarily on ratings, guarantees from monoline insurers, and a blind reliance on historical experience of the 2003–2006 credit boom to anchor future performance expectations, especially in housing and commercial real estate.

The illiquidity and credit losses investors experienced during this period led many to steer clear of ABF, often preferring corporate credit. In the years that followed the GFC, however, the ABF market underwent a painful yet necessary transformation: market participants, including investors, issuers, arrangers, and rating agencies, returned to sustainable credit underwriting. Diverse, appropriately capitalized, cautious buyers stepped into the vacuum created by the disorderly departure of overly levered, correlated investors, thereby improving market liquidity and stability.

Despite these developments, losses and volatility always have the potential to return to certain corners of ABF. Structured credit (the $3.3 trillion ABF subsector of tradeable non-government securities) was not immune from downward ratings drift during the early stages of the COVID pandemic, similar to that experienced across other asset classes. However, structured credit in aggregate realized lower default rates in 2020 than corporate credit peers, and even fewer than their own historical average. For example, CLOs did not experience a single default during all of 2020, and only five in 2021, according to S&P. This compares favorably to the high-yield bond market, which recorded default rates as high as 9 percent in August 2020, and the leveraged loan market, which recorded a default rate of 4.2 percent in September 2020.

Identifying which specific ABF types, structures, and securities may experience a dislocation requires dedicated credit, trading, technology, and legal teams, and a disciplined investment process.

Asset-Backed Securities: An Established Niche within the Massive Asset-Backed Finance Ecosystem

The broader ABF ecosystem includes collateral as diverse as aircraft leases, residential mortgages, data centers, and royalty agreements. Within this large market, significant segments of private bilateral transactions remain inaccessible to smaller investors, while certain areas of the tradeable ABS market are often overlooked by larger investors seeking greater scale.

Making ABS: Securitizing Assets and Contractual Cash Flows

The making of an asset-backed bond—that is, the process we call securitization—begins with a simple agreement. One party agrees to pay another party. A family buys a home and agrees to monthly mortgage payments. A software company borrows money to purchase a smaller competitor and agrees to the terms of a bank loan. A regional airline, looking to add routes, enters a lease agreement on an Airbus A320. A franchisee opens a drive-through restaurant and agrees to pay 5 percent of sales to Wendy’s Corp.

Look beyond the house, the software company, the airplane, and the restaurant. These agreements are all contractual obligations to pay that form the basic building blocks of securitization: they comprise the assets backing the securitization.

You may be the proud owner of a vast vinyl record collection. Your record collection, however, doesn’t belong in an ABS deal. To serve as the collateral backing an asset-backed security, an asset must represent a contractual obligation to make payments. In other words, the assets on the left-hand side of the securitization’s balance sheet also exist as liabilities on the right-hand side of the payer’s balance sheet. Note that we refer to a “payer,” because an asset may represent the obligation to pay by a borrower, lessee, customer, or licensee, among others. Contrary to common understanding, “hard” assets do not serve as the primary collateral for securitizations. Only contracts, such as leases, mortgages, loans, and agreements that define payment obligations create the contractual cash flows necessary for securitization.

Other sources of value, such as real estate, airplanes, or a corporate guarantee, may also be available to repay ABS investors. However, these provide only secondary security. Disciplined structured credit investors rely primarily on contractual cash flows for repayment; these other sources of value represent methods of repayment only in break-glass-in-case-of-emergency situations. Experienced and capable ABS investors seek structures and collateral that avoid direct reliance on such secondary sources of value because the history of markets has shown that the root cause of a disruption in a payer’s ability to honor a contractual obligation to pay will simultaneously lead to a depreciation in the value of the related hard assets (they share a “common risk factor”).

For example, when large numbers of homeowners could not honor their mortgage payment obligations, counting on steady housing prices to support debt repayment turned out to be unrealistic. Leading up to the GFC, those who conservatively evaluated borrowers’ ability to pay their mortgages rather than focusing on property values generally sidestepped losses (and, in some cases, gained the insight to short the ill-constructed securitizations). Meanwhile, those investors who relied on continued home-price appreciation and ignored the quality of the contractual cash flows fared poorly. We believe the ultimate value returned on any investment in real estate, companies, planes, ships, and intellectual property will derive from the quality of the underlying cash flows, not the other way around.

SPVs: The Structure of Structured Credit

Securitization begins with the creation of a special purpose vehicle, or SPV. Think of an SPV as a company with no purpose other than to acquire assets and issue debt secured by those assets.

The SPV, also called the “issuer,” purchases a specific pool of assets and simultaneously issues debt securities—the asset-backed securities—and equity interests to fund the purchase of those assets. The pool of assets is typically of one type (auto loans, aircraft leases, corporate loans, etc.), but often is comprised of diverse and numerous “payers.”

Often, but not always, the SPV issues multiple classes of debt with different priority of payment, which are called tranches. Other important steps in this securitization process include the assignment of a servicer or manager, assignment of a trustee, issuance of a rating on the issued debt tranches, and the establishment of an assortment of rules to govern the securitization. These rules dictate how the trustee distributes cash flow from the asset pool between the principal and interest due on the debt tranches and equity interests, what sort of assets the SPV can own, what to do when assets pay off early, and whether cash can be used to purchase new assets. They also prescribe what happens when things go wrong, such as when the assets do not generate enough cash, or there is a precipitous decline in their quantity and/or quality.

The governing documents also establish the content of the periodic investor reports, spelling out the roles, ratings, and rules, and much more. Usually, the bond indenture serves as the governing document, but some securitizations may use a credit agreement, a trust deed, or a servicing agreement. Navigating these documents efficiently and thoroughly requires significant experience, dedicated resources, and a disciplined investment process.

More than MBS: ABS Collateral Types Are Familiar and Diverse

At its inception in the mid-1980s, the non-mortgage ABS market began with securitizations of auto loans and credit card receivables. Since then, the sector has rapidly evolved into a highly diversified $1.6 trillion market, running the gamut of collateral types. Within structured credit, investors can construct a portfolio of various collateral types, providing additional diversification benefits at the investor portfolio level. Real estate-related securitized credit, including Agency and non-Agency RMBS and CMBS, are subsectors of ABF, but their investment considerations differ significantly enough that we consider them distinct subsectors relative to non-real estate ABS.
Non-real estate ABS collateral types can be grouped into two main subsectors, consumer and commercial:

• Consumer ABS are backed by cash flows from personal financial assets, such as student loans, credit card receivables, and auto loans.
• Commercial ABS are constructed from pools of business receivables, loans, or leases on assets, such as shipping containers, data centers, aircraft, and other commercial equipment. Commercial ABS also include collateralized loan obligations (CLOs) backed by corporate bank debt or commercial real estate loans, and, on occasion, collateralized bond obligations (CBOs) backed by high-yield bonds.
• Other non-mortgage securitized assets include merchant credit card advances, oil and gas future production royalty agreements, commission agreements, drill-ship charter agreements, property assessed clean energy loans, wireless tower leases, billboard leases, consumer wireless contracts, and wireless spectrum agreements. For a more comprehensive list of ABS types, see Appendix A.

Investor-Friendly Features of ABS

ABS include investor-friendly features intended to help protect against loss and improve liquidity, including bankruptcy remoteness, excess spread and triggers, overcollateralization, diversity of payers, amortization, and debt tranching.

Bankruptcy remoteness: Most securitizations involve a sponsor, typically a lender, specialty finance company, institutional investor, or corporation. If that sponsor gets into financial trouble, it can usually file for protection of its assets from creditors under the bankruptcy code, forcing all creditors into a standstill. However, in a securitization, the SPV that issues the debt is separate and distinct from the sponsor. Bankruptcy protection for the sponsor does not extend to the liabilities of the SPV. Further, the assets of the SPV will not be available to the sponsor’s other creditors, providing ABS investors with a layer of protection from financial stress experienced by the sponsor.

Excess spread and triggers: As illustrated below, the expected yield or return of the underlying asset pool usually exceeds the average yield of the issued ABS debt.

Closely tied to the concept of cash flow tranching, most securitizations provide for amortization, or return of principal, ahead of the expected maturity, which may mitigate risk of loss without any investor action or hedging. The most prominent example is in RMBS where collateral prepayments are the majority contributor to bond amortization. Compare this to corporate or municipal debt where amortization is rare and a large principal payment by the borrower at maturity (usually from refinancing proceeds) are typically required, introducing term or maturity risk. As a result, securitized credit investors usually take less borrower refinancing risk than corporate or municipal debt investors or commercial mortgage lenders².

Professional servicing and active management: The servicer, also referred to as the collateral manager, seeks to maximize the certainty and quantity of cash flows from the underlying pool of assets. Responsibilities of the servicer may include evaluating credit quality of payers and assets prior to inclusion in the pool, negotiating pricing and terms of loans and leases, remarketing equipment for lease, negotiating with nonperforming lessees or borrowers, obtaining appraisals, and selling hard assets. In many transactions, the servicer or an affiliate owns the equity or residual interest in the securitization, which generally creates a favorable alignment of interest with the debt investors. A major distinction exists between static pools and actively managed pools. In static pools, cash flows from the collateral may not be reinvested in new collateral. In actively managed, or reinvesting, securitizations, the manager may purchase new assets with proceeds received from existing assets, subject to strict eligibility criteria.

Investment-grade ratings: Securitizations represent a bankruptcy remote lien on diverse, contractually cash flowing assets, and consequently rating agencies generally assign investment-grade ratings to many of the issued debt tranches. However, the repayment of debt relies on contractual cash flows and does not generally benefit from recourse to the sponsor or asset originator. As a result, securitized debt ratings rely heavily on those contractual cash flows, many of which can persist for many years irrespective of the success or failure of the sponsor’s business plan.

Accordingly, even though most securitizations are expected to mature within one to 10 years’ time, rating agencies often commit to supporting investment-grade ratings for periods of over 20 years on bonds with a combination of long-term collateral cash flows and structural protections that should provide for principal recovery even in adverse or recessionary periods.

Professional reporting: Each securitization employs a third-party trustee that, among other responsibilities, distributes periodic performance reports to investors. These reports, generally prepared by the servicer, relay information about the underlying collateral’s composition, quality, and payment performance. While the content of the reports varies by securitization type, in each case these reports meaningfully contribute to liquidity and facilitate risk management, as they allow existing and prospective investors to evaluate the performance and outlook of the securitization.

ABS: What’s In It for the Borrower?

Securitizations provide debt capital to two types of borrowers: They may fund the loans or leases originated by lenders, lessors, or other specialty finance companies. Alternatively, securitizations may provide debt capital to traditional corporate borrowers who have contracts or own assets that are of higher financial quality than their own full faith and credit.

For all borrowers, a benefit of securitization is that the term of ABS borrowing matches the term of the underlying assets, insulating them from mark-to-market or refinancing risks. From the traditional corporate borrower’s perspective, the benefits of financing through securitization include:

• Term of financing matches tenor of assets, reduces refinancing risk, and eliminates potential for forced asset sales
• Lower borrowing costs than alternatives such as senior unsecured bonds
• Non-recourse to the sponsor, may provide off-balance sheet treatment
• Diversity of funding sources may improve enterprise valuation for sponsor

In each case, borrowers pledge loans, leases, or other securitizable assets as collateral that exceeds the same borrower’s intrinsic creditworthiness. In other words, the securitization investor tables the difficult question, “Will the borrower repay me?”—indeed, payments are not guaranteed by the corporation—and instead asks the simpler question: “Will these assets (loans, leases, etc.) generate enough contractual cash flow to repay me?”

The following case study illustrates the benefits of securitization to a traditional corporate borrower. This $2 billion securitization by Domino’s Pizza employed the basic structure, mechanics, and priority of payments for ABS. In contrast to multi-tranche ABS structures, this securitization is characterized by a single-term tranche of debt and a pari-passu (equal rank to the term tranche) revolver backed by the same assets.

Investing in ABS

Any investor considering an allocation to ABS should ask two questions to understand pricing of the sector.

A prospective ABS investor should consider two questions: First, despite the previously mentioned risk-mitigating attributes of securitization, why has structured credit, and specifically the non-mortgage ABS subsector, continued to offer additional yield when compared to similarly rated corporate, municipal, or Agency debt? Second, within structured credit, which factors help investors understand the relative pricing of different ABS?

As to the first question, the reasons for ABS’s yield premium mostly concern liquidity, information discrepancies, and historical experience:

• Most broad market indexes, including the Bloomberg U.S. Aggregate Bond Index, do not include many types of structured credit securities. Investors thus perceive, unfairly in some cases, reduced liquidity versus competing fixed-income products.
• Structured credit securities trade over the counter, not on an exchange or electronic trading system.
• ABS reporting, while appropriate for their structure, does not resemble the quarterly disclosures of traditional corporate borrowers. This may tend to hinder crossover interest from traditional corporate debt investors.
• A shifting regulatory landscape has created uncertainty, particularly for banks’ capital charges.
• Price volatility, rating downgrades, and credit losses experienced during the global financial crisis still haunt some securitized credit investors.
• Finally, the complexity of the documentation and structure of ABS and other securitized products requires a deeper investment in the necessary resources, including human capital, technology, and data, as illustrated by the exhibit on previous page.
• Note that none of these reasons are related to creditworthiness or the likelihood of return of full principal and interest. Rather, the reasons are all technical, which supports our belief that structured credit, in general, offers attractive incremental return without additional risk of loss.

For the answer to the second question, investors will need to consider a number of key variables when negotiating pricing:

• With regard to the underlying assets, investors should consider the liquidity, diversity, and transparency of the underlying asset and the availability of accurate historical performance information to inform stress scenarios.
• With regard to the ABS securities themselves, investors should factor into pricing such characteristics as rating, credit enhancement, position in capital structure and tenor, the effectiveness of portfolio limits, triggers, and covenants, and each tranche’s ability to withstand hypothetical stress scenarios.
• Equally important in evaluating pricing are such factors as the allowance for reinvestment in new collateral, call protection, availability of effective hedges, the manager’s resources and track record, and the quality of periodic reporting.

Liquidity in ABS

ABS are generally considered less liquid than similarly rated corporate bonds. If we focus on a subset of the commercial ABS market, whole business securitizations, it is true to say that there is less total trading than in the broad investment-grade rated universe, which traded $6.4 billion in 2024. Nevertheless, secondary trading in whole business securitizations exceeded $3 billion in 2024. Additionally, whole business securitizations have roughly one third the turnover of investment-grade corporates, indicating that these bonds are typically held by long-term investors.

Lower volumes do not necessarily equate to less liquidity. We define liquidity as ability to sell at the mark (provided by a third party pricing service) at any point in time. Over a variety of markets, the ability to sell a whole business securitization at the mark is nearly identical to the ability to sell large investment-grade benchmark transactions ($1 billion + tranche size) at the mark. There are very few periods since 2020 where the trade price during periods of volatility has been more than 0.5 percent lower than mark.

Common Mistakes in Structured Credit Investment

When examining ABF structures that have “gone bad” over the years, we commonly find that investors failed to rationally assess one or more of the below risks. A disciplined, thorough investment process and common sense will help guard against these common missteps.

• Focusing on enterprise value, hard asset values, or sponsor reputation instead of the contractual payer’s ability, willingness, and incentives to pay.
• Overreliance on rating agencies in lieu of independent credit work and commercial judgment.
• Failing to anticipate correlated outcomes, particularly the strong connection between payer performance and hard asset values in times of distress.
• Overreliance on quantitative models calibrated on historical data to forecast credit performance in changing market regimes. This problem is magnified in subordinated tranche investments and their inherently non-linear loss profiles.
• Failing to anticipate collateral obsolescence or technological advances diminishing residual values or prospects for new contracts.

Overview of Guggenheim’s Structured Credit Investment Process

To confidently enter the structured credit market, an investor needs to have the necessary resources, including human capital, technology, and data. At Guggenheim Investments, we believe we not only have the resources for rigorous security analysis, but we also have built a disciplined investment process. The diagram below illustrates the process we employ to source, evaluate, and select investment ideas.

Structured credit represents a unique challenge for asset managers. Strong capabilities in corporate credit analysis are an absolute necessity when evaluating structured credit given its complexity as an asset class. Asset management firms without a substantial structured credit team, corporate credit team, legal team, and a dedicated portfolio construction group may overlook important factors when determining suitability.

Guggenheim’s fixed-income investment team manages or updates credit opinions on an ongoing basis. This pre-existing research allows our structured credit team to form a comprehensive view of any structured credit’s relative merit. The legal documents associated with each distinct deal within a structured credit contains nuances, which may require collaboration with our team of dedicated legal professionals.

Appendix: Selected ABS Types and Related Data