Asset-backed securities – how and why we use them in our portfolios

First of all, what are ABS?

ABS are financial instruments, created by pooling assets such as mortgages, car loans, credit cards and student loans. These are then packaged into what are known as ‘special purpose vehicles’ or SPVs, which are legally separate from the banks which issue them. This structure means that even if the issuing bank fails, the underlying assets continue to generate income for investors.  

Because of their association with the 2008 financial crisis, ABS are often misunderstood or even mistrusted. But the key lies in using them responsibly, understanding the risk and structuring them in a way that helps protect investors. 

The benefits of using ABS

There are a number of compelling reasons to use ABS, including: 

• Higher yield for equivalent risk: compared to traditional corporate bonds, ABS can deliver superior returns for similar levels of risk. 
• Floating rate exposure: most ABS are floating rate instruments, meaning they’re resilient in rising interest rate environments. 
• Diversification: ABS portfolios often include thousands of individual loans, reducing the risk of concentrated defaults. 
• Bankruptcy remoteness: investors are protected if the issuing bank fails, as the SPV which ABS are packaged in holds the assets independently. 

Understanding the risk structure of ABS

ABS are divided into tranches, each with different levels of risk and return – AAA, AA, A, BBB and equity. The AAA tranche is the most secure and there would need to be extreme scenarios, such as a 40% drop in house prices and default rates 50 times higher than historical peaks, before investors would begin to lose money. 

These tranches mean that investors can choose their desired level of risk and return. For example, the AAA tranche offers lower potential returns but greater security, while the mid-level tranches, such as BBB, offer higher potential returns but increased risk. 

Royal London Asset Management’s approach

Royal London Asset Management has two ABS-focused funds which the Governed Range portfolios invest in: 

• Senior Fund: targets AA to single A-rated assets, aiming for returns of around 1.25% above cash. 
• Mezzanine Fund: targets BBB-rated assets, aiming for returns of around 2.25% above cash. 

Both these funds offer floating rate returns and access to diversified consumer credit risk. They’re used across the Governed Range portfolios, apart from in the two highest-risk Governed Portfolios – Governed Portfolio Dynamic and Governed Portfolio Total Equity. 

In conclusion

ABS are no longer seen as niche or opaque assets. With the right research and structuring, they offer attractive returns, diversification and, importantly, a level of protection for investors. We also believe that they can enhance portfolios, especially in environments where traditional fixed income assets struggle to deliver.

For more information, download our asset-backed securities in multi asset portfolios guide or speak to your usual Royal London contact.