What is an asset-backed security (ABS)?

An asset-backed security (ABS) is a financial instrument that is created by pooling together various financial assets, such as loans, leases, credit card debt, or receivables, and then issuing securities that are created based on these cash flows. The cash flows generated from the underlying assets are used to pay the principal and interest to the ABS investors. This means that the value of the ABS is directly tied to the performance of the underlying assets, providing a way for investors to gain exposure to different types of assets in a more liquid form.

The other options are less accurate representations of what asset-backed securities are. Dividends are typically associated with stocks, particularly those of established companies, rather than ABS, which are structured around cash flows from asset pools. Government bonds are debt securities issued by governments to raise funds, whereas ABS are not specific to any government body and are issued by a range of entities, including financial institutions. Real estate investment trusts (REITs) invest directly in real estate and generate income primarily from property leasing, which does not align with the structure and purpose of ABS. Thus, the choice correctly identifies an ABS as a financial security backed by a diverse pool of assets.