Diversifying with Debt: A Look at Asset-Backed Investment Strategies

Diversification is a fundamental principle of investing, allowing investors to spread risk across different asset classes and investment vehicles. In recent years, there has been a growing interest in asset-backed or debt-backed investment strategies as a means of achieving portfolio diversification and generating attractive returns. In this blog, we’ll explore what asset-backed investments and debt funds are and how they work.

Understanding Debt-Backed Investments

Asset-backed investments (ABS), also known as debt funds in some cases, are financial instruments backed by a pool of underlying assets. These assets can include loans, mortgages, credit card receivables, and other forms of debt. The cash flows generated by these assets are used to pay interest and principal to investors who hold the securities. ABS are typically structured into funds with varying levels of risk and return, allowing investors to choose investments that align with their risk tolerance and investment objectives.

How Debt-Backed Investments Work

Asset-backed investments work by pooling together a diverse set of debt instruments and transforming them into tradable securities. These securities are then sold to investors who receive regular interest payments based on the cash flows generated by the underlying assets. The risk and return characteristics of debt-backed investments vary depending on factors such as the underlying assets’ credit quality, the securities’ structure, and prevailing market conditions.

Popular Asset-Backed Investment Types

In principle, an asset-backed security can be constructed using virtually any income-generating source, ranging from mobile home loans to utility bills. However, there are specific types that are more prevalent. Some of the common ABS varieties include:

  • Mortgage-Backed Securities (MBS): These securities are backed by pools of residential or commercial mortgages, providing investors with exposure to the real estate market. More on this later.
  • Collateralized Loan Obligations (CLOs): CLOs are backed by pools of corporate loans, offering investors exposure to corporate debt markets.
  • Home Equity ABS: These are loans taken out against the equity in a home, typically by borrowers with lower credit scores or fewer assets, structured as amortizing loans with payments allocated to interest, principal, and prepayments.
  • Auto Loan ABS: Auto loan ABS involves cash flows made up of monthly interest payments, principal payments, and infrequent prepayments, given the lower prepayment rate compared to home equity loan ABS, all structured as amortizing loans.

Rising Interest in Asset-Backed Investment Strategies

There are several reasons why investors are increasingly turning to asset-backed investment strategies:

  1. Diversification: Debt-backed investments offer diversification benefits by providing exposure to different sectors and asset classes beyond traditional stocks and bonds.
  2. Yield Generation: With interest rates in some sectors at lower levels than in other historical periods, investors are seeking alternative sources of yield, and asset-backed investments can offer attractive risk-adjusted returns and an opportunity to be on the receiving end of interest-rate fluctuations.
  3. Risk Management: Debt-backed investments can help manage portfolio risk by providing stable cash flows and reducing overall volatility.
  4. Inflation Hedge: Certain types of debt-backed investments, such as inflation-linked bonds, can provide protection against inflationary pressures by adjusting interest payments based on changes in inflation rates.

Understanding the Distinction: MBS vs. ABS

Asset-based securities (ABS) and mortgage-backed securities (MBS) may seem similar at first glance. However, there are a few crucial differences. While both function as securities paying a fixed interest rate based on a pool of income-generating assets, the core disparity lies in the composition of these assets. As the name suggests, MBS comprises a bundle of mortgages or real estate loans. In contrast, ABS typically represents diverse financing sources, such as student loans, auto loans, or credit card debt.

There exists some variation in how institutions classify ABS and MBS. Some consider ABS a broad term encompassing all securitized investments based on asset pools, including MBS within its scope. At the same time, others maintain a clear distinction between ABSs and MBSs.

Exploring Mortgage Pools and Alternative Investments

At Cooper Pacific, we specialize in mortgage pools and alternative real estate investments, allowing investors to diversify their portfolios with asset-backed securities. Diversifying with debt-backed investment strategies can help to achieve portfolio diversification, generate attractive returns, and manage risk in today’s challenging market environment. Whether you’re a seasoned investor or new to alternative investments, exploring the potential benefits of debt-backed securities can help you achieve your financial goals confidently and successfully.

Contact Jordan on our team to learn more about how mortgage-backed securities can enhance your investment portfolio.

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