Asset Backed Securities vs Mortgage Backed Securities: Which One Is Right for You

Explore the wave of alternative investments captivating global investors. Today’s new generation seeks diversification beyond gold and real estate, exploring avenues like sustainable investing, REITs, cryptocurrencies, and asset-based securities.

Consider asset-backed securities—a concept where banks transform loans into investment prospects. Our blog covers the ABCs of Asset Backed Securities Vs. Mortgage Backed Securities, delving into cash flow modeling and various types available. Understanding your preferences is crucial for making astute investment decisions.

Join us as we explore the world of ABS and MBS. 

What is an Asset-Based Security?

In simple terms, Asset Backed Security(ABS) is a type of Investment where a bunch of interest-generating instruments is clubbed together, which includes student loans, credit cards, and home loans.

Now banks or NBFCs group these assets (loans) to create a special purpose vehicle for investors. Let’s call it a note or bond. As an investor, you will earn a fixed interest rate regularly from the money the bank receives from the cash flow of these loans.

What is a Mortgage-Based Security?

Mortgage-Backed Securities (MBS) is a type of ABS. In India, mortgage-backed loans are bundled together to create MBS. As an investor, you can purchase these MBS and earn a fixed income from the monthly mortgage payments made by borrowers.

Therefore, rather than being considered separate, it Asset Backed Securities Vs. Mortgage Backed Securities,  MBS, is part of the broader category. Now lets move ahead towards the different types of ABS and MBS.

What Are the Types of ABS and MBS Available in the Market?

In the debate of Asset Backed Securities Vs Mortgage Backed Securities, it is necessary to understand the types of ABS and MBS available in the Market for investors.

Types of Asset Backed Securities (ABS)

Home Equity ABS

Home Equity Loans (HELs) are a type of asset-backed security representing a pool of loans made to homeowners who borrow against the equity in their homes. The loans are secured by a second lien on the borrower’s home and are typically used for home improvements or debt consolidations.

Auto Loan ABS

Auto Loans are another type of asset-backed security for a pool of loans made to borrowers who use the funds to purchase a vehicle. The asset itself typically secures these loans, and the cash flows from the loan payments are passed on to investors as interest and principal payments.

Credit Card Receivables ABS

A pool of credit card receivables supports this kind of ABS. The cash flows come from the payments made by credit cardholders to repay their outstanding balances.

Student Loan ABS

In this type of ABS, the cash flows come from the monthly repayments made by students, graduates, or post-graduates who borrowed money from a bank or financial institution to finance their education.

Collateralized Loan Obligations (CLOs)

This ABS include corporate loans. Here the manager purchases corporate loans created by financial institutions. These loans are typically granted to businesses that need funds for either expansion or operations. And are collateralized against asset or operating cash flows. The earnings for investors come from the interest and principal payments made by the borrowing companies.

Types of Mortgage Backed Securities (MBS)

Let’s understand the types of Mortgage Backed Securities thoroughly 

Pass-Through Certificates (PTCs)

Pass-through certificates specifically represent a type of MBS that distributes earnings on a pro-rata basis amongst their investors. As an investor holding pass-through certificates, you will receive a portion of the mortgage payments collected from the homeowners in the pool. PTCs usually have either five, fifteen or thirty years of maturity. 

Residential Mortgage Backed Securities (RMBS)

RMBS are investments created by pooling together many residential mortgage loans. Individuals use these loans to finance the purchase of homes or other residential properties. When people make their monthly mortgage payments, a portion is passed on to RMBS investors, who receive a pro-rata share.

Commercial Mortgage Backed Securities 

 CMBS are similar to RMBS, but a pool of commercial mortgage loans backs them. These loans finance commercial properties such as office buildings, shopping centers, or hotels. When the businesses that own these properties make their monthly mortgage payments, a portion of that payment is passed on to CMBS investors, who receive a pro-rata share of the payments.

Stripped Mortgage Backed Security 

SMBS is a type of MBS split into two parts: Interest-only SMBS and principal-only SMBS. Talking about interest-only SMBS, the payment comes from interest received from the mortgage payments. This means that investors only receive the interest portion of the mortgage payments made by homeowners. On the other hand, in the case of principal-only SMBS, payment is associated to the principal received from the mortgage payments. 

Cash Flow Modeling for Asset Backed Securities vs Mortgage Backed Securities

Cash flow modeling for Asset Backed Securities Vs Mortgage Backed Securities involve analyzing and projecting the expected cash flows from the underlying assets to assess the investment performance. Here’s how the cash flow modeling process works in Asset Backed Securities vs Mortgage Based Securities.

Collateral Cash Flows

The collateral cash flows in Asset Backed Securities Vs Mortgage Backed Securities

follow the suit of their names, as in ABS cash flow modeling focuses on cash flow generated by ABS collateralized assets., and MBS focuses on cash flows generated by the underlying mortgage loans.  

Tranche Structure 

In Asset Backed Securities Vs. Mortgage-Backed Securities, ABS generally have a tranche structure where the diversifying assets are classified into three tranches: Class A, Class B and Class C. 

These are in descending order based on their ratings. For instance, class A has a higher investment rating than Class B and Class C. These ratings are for investors to analyze the quality of credit.

So, cash flow structures differ between Asset Backed Securities Vs. Mortgage Backed Securities. ABS generate income from the cash flows generated by the underlying assets, while MBS derives cash flows from the mortgage payments made by homeowners. Investors should determine their preference for predictable cash flows (MBS) or potentially diversified income streams (ABS).

What Are the Risks Associated with Asset Backed Securities vs Mortgage Based Securities?

Even though ABS and MBS are touted as different kinds of securities, it was well established that they are part of each other, so the risk associated is also the same. Asset-backed securities vs Mortgage-backed securities carry certain risks that investors should be aware of. Here are the risks associated with MBS and ABS.

Credit Risk

There’s a risk that borrowers may miss making their mortgage payments, which can affect the cash flow to MBS and ABS investors. If many borrowers default, it can impact the returns on MBS investments.

Prepayment Risk

Borrowers may also decide to pay off their mortgages earlier than expected, especially when interest rates are low. This can reduce the duration of MBS investments and potentially lower investor returns.

Interest Rate Risk

Fluctuations in interest rates can affect MBS and ABS. Fewer homeowners refinance or buy new homes when rates rise, leading to fewer mortgage payments. Conversely, when rates drop, more homeowners may choose to refinance, impacting the expected returns for MBS investors.

Market Risk

Both Asset Backed Securities Vs. Mortgage Backed Securities, broader market conditions can influence Asset Backed Securities. Changes in the economy, consumer behavior, or industry-specific trends can impact the performance of the underlying assets and, subsequently, the cash flows received by investors.

The Final Words: Asset Backed Securities vs Mortgage Backed Securities

The decision for investors on difference between Asset Backed and Mortgage-Backed Securities ultimately depends on individual preferences and investment goals. If an investor seeks portfolio diversification across various student loans, car loans, or credit card repayments, ABS would be the suitable choice. On the other hand, for exposure to the residential market, MBS offers a wide range of securities.

Additionally, investors should carefully consider their risk appetite, desired cash flow structure, and frequency of cash flows, as ABS and MBS have different risk profiles and cash flow frequencies. It is essential to stay informed about market conditions and interest fluctuation and how they may impact the performance of these securities.

In summary, the verdict for investors in Asset Backed Securities vs. Mortgage Backed Securities hinges on individual factors such as risk tolerance, cash flow requirements, market conditions, and investment objectives. Investors can make well-informed decisions by assessing these aspects and conducting thorough research. Seeking guidance from a financial advisor can provide valuable insights and support throughout the decision-making process.