The ABCs of ABS, and how Vanguard finds value for investors

Key takeaways

• Asset-backed securities (ABS) offer compelling benefits for your clients, including shorter duration, core portfolio diversification, and higher income potential.
• Modern ABS structures provide robust investor safeguards, with legal defenses and deeper layers of structural protections that help mitigate default risk.
• Despite recent high-profile defaults, the ABS market has matured. With rigorous investment processes, active managers can achieve strong risk-adjusted returns.

You may have noticed that Vanguard has been expanding its use of asset-backed securities in its actively managed bond funds.

If you invested during the global financial crisis (GFC), or if you have been concerned about some relatively recent credit blow-ups, ABS may feel extra risky. But maybe look again: ABS typically comes with credit elements that are more durable than may be broadly appreciated. 

ABS—financial instruments created by pooling together assets that generate cash flows, then issuing securities backed by those assets—are a key fixed income sector to understand because they offer the opportunity for your clients to achieve stronger risk-adjusted returns.

Why consider bond funds with ABS?

• Shorter duration. ABS tend to be issued with shorter terms to maturity than corporate bonds. That gives them less sensitivity to interest rate increases, which cause the prices of bonds to fall.
• Core exposure. Securitized credit—excluding agency mortgage-backed securities—is a $3.5 trillion market (Bloomberg data as of December 31, 2025). Securitized credit represents a pillar for portfolios, not an offshoot.
• Higher income. ABS comes with a yield pickup for the same or similar level of credit quality, usually because it’s a smaller market with fewer participants, as well as an illiquidity and complexity premium that can be added in. 

Reverberation from recent defaults

The spotlight fell again on asset-backed securities back in September after First Brands and Tricolor both declared bankruptcy. First Brands had issued $2 billion in leveraged loan obligations, according to PitchBook. Those loans were packed into a collateralized loan obligation, a form of ABS, which had to absorb losses. Tricolor, which sold automobiles to borrowers with little or poor credit history, had nearly $1 billion in ABS outstanding.

Those blow-ups may bring back memories of the GFC, when many holders of AAA rated MBS found themselves suffering dramatic losses as foreclosures and defaults piled up.

The post-GFC ABS market has learned from the crisis, and many sectors have always been strong from a credit perspective.

Stronger default safeguards

Legal defenses in ABS can far exceed those for corporate bonds.  

Legal trust: Corporations that make loans transfer those loans to a legal trust, often called a special purpose vehicle. The trust then owns the assets, creates the ABS, and sells those on the market before paying back the corporate entity.

But if the corporation declares bankruptcy, creditors cannot seek access to assets that have been transferred to the trust, and bankruptcy courts have consistently protected the trust structure as an independent entity.

• Because of the legal protections, ABS bond holders can’t be “primed,” that is, put in a lower tier to be paid back as other creditors offer distressed financing.

Structure: ABS are structured with tranches—layers of risk and return within an ABS. Higher tranches have higher priority: They get paid first and are less exposed to losses, while lower tranches offer higher yields but are more exposed to losses if defaults on the underlying loans occur.

• Since the GFC, ABS often includes an equity stake—that absorbs losses first, and typically exceeds losses experienced in the GFC, providing a thick layer of cushion. That equity stake is followed by mezzanine tranches (for example, rated B), and finally the top tranches (for example, AAA), which are last in line for defaults. AAA tranches receive both principal and interest payments first. Once the AAA tranche is paid off, principal payments flow to AA tranches, which may then be upgraded to AAA.
• Investors can choose their risk level and are compensated accordingly. The highest rated tranches yield less, while the tranches below offer higher yields and the potential for credit upgrades.

On the risk spectrum, most corporate bonds carry a lower credit rating than ABS.

Vanguard’s team and process

At Vanguard, the Structured Product team covers ABS, as well as commercial mortgage-backed securities, non-agency residential mortgage-backed securities, and collateralized loan obligations. We aim to leverage deep market knowledge to deliver consistent alpha through an active and scalable investment process. We have:

• Extensive market coverage: The eight-member active team manages over $23 billion across more than 20 subsectors, covering over 92% of the structured products market.  To mitigate risk, we purposely avoid weaker sectors like aircraft ABS and many subprime auto issuers, like Tri-Color.
• Robust process design: The team follows a structured process using trusted methods and specialized tools. They perform detailed reviews of collateral, structure, and issuers, supported by strong relationships and procedures to manage risk effectively.
• Industry-leading surveillance: The securities-monitoring process includes monthly reviews and stress testing to avoid downgrades and manage workout scenarios effectively. For example, our vigilance kept us from becoming panic sellers of Hertz when the company filed for bankruptcy during the COVID-19 pandemic. The rental car company’s ABS ultimately resulted in full return of principal and no loss of interest.
• A proven track record: Over the past decade, the team has generated value for our lineup through relative-value trading and defensive positioning during periods of widening spreads.

Some Vanguard active fixed income funds or ETFs with structured products:

Multi-Sector Income Bond ETF  Up to 20%

Multi-Sector Income Bond Fund Up to 20%

Ultra-Short Bond ETF 15% to 25%

Short-Duration Bond ETF 5% to 15%

Core-Plus Bond ETF up to 10%

Core-Plus Bond Fund up to 10%

Core Bond ETF up to 10%

Core Bond Fund up to 10%

Notes:

For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Vanguard Multi-Sector Income Bond ETF is not to be confused with the similarly named Vanguard Multi-Sector Income Bond Fund. These products are independent of one another. Differences in scale, certain investment processes, and underlying holdings between the ETF and its mutual fund counterpart are expected to produce different investment returns by the products.

Vanguard Core Bond ETF and Vanguard Core-Plus Bond ETF are not to be confused with the similarly named Vanguard Core Bond Fund and Vanguard Core-Plus Bond Fund. These products are independent of one another. Differences in scale, certain investment processes, and underlying holdings between the ETFs and their mutual fund counterparts are expected to produce different investment returns by the products.

All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.