Covered Bonds

What are Covered Bonds?

A covered bond is a financial instrument comprising a pool of assets, such as mortgage loans and public sector loans, issued by banks. These bonds, with a soft bullet structure, represent a dual recourse arrangement where the underlying pool of assets remains on the issuer’s balance sheet, forming cover pools. This collateral pool provides an added layer of security for covered bondholders.

The covered bond markets operate under specific regulations overseen by entities like the European Covered Bond Council. The bonds, often considered high-quality debt instruments with preferential claims, serve as a secure investment for covered bond investors. The issuance of covered bonds is subject to legislative covered bonds frameworks to ensure the maintenance of sufficient assets and compliance with credit quality standards.

Covered Bonds Explained

Covered bonds, recognized as a cost-effective financing tool for lenders, offer an alternative to the issuance of unsecured debt instruments, contributing to the expansion of their businesses. These bonds, akin to residential mortgage-backed securities (MBS) and asset-backed securities (ABS), operate within a structured framework. A bank initiates the process by selling a pool of financial assets, including mortgages or public sector loans, to a financial institution. The European Covered Bond legislation provides guidelines for this transaction, emphasizing the establishment of a cover pool that remains on the issuer’s balance sheet.

The issued covered bonds, similar to debt securities, represent investments where the interest payments are sustained by the cash flows generated from the underlying loans. This cash flow mechanism ensures a steady income stream for covered bondholders. To manage risk, financial institutions have the flexibility to replace defaulted or prepaid loans with performing ones within the cover pool, maintaining the overall credit quality of the bonds.

Notably, covered bonds have gained prominence in Europe, operating under the oversight of entities like the European Covered Bond Council. This market has showcased resilience, even in the face of financial crises, highlighting the bonds’ secure nature. While covered bonds are more prevalent in Europe, there is a growing interest in the U.S. financial market, reflecting a potential expansion of this financing instrument globally.

Benefits of Covered Bonds

1.     Lower Risk. Covered bonds are renowned for their lower risk profile compared to other debt securities. This stems from the specific pool of high-quality assets, such as residential mortgages or commercial mortgages, that backs these bonds. In the event of covered bond issuers default, bondholders enjoy priority over other unsecured creditors, ensuring access to the assets supporting the bond.

2.     Additional Source of Funding. Serving as an additional source of funding, covered bonds provide lending institutions, primarily banks, with a valuable resource to finance their lending activities. This becomes particularly crucial during economic stress when traditional access to funding may become more challenging. The bonds offer financial institutions a stable avenue for securing funds to support their operations.

3.     Dual Recourse. One of the distinctive features of covered bonds is their dual recourse structure. Bondholders not only have a claim on the creditworthiness of the covered bond issuer but also on the assets backing the bond. This dual recourse provides an added layer of protection for investors, making covered bonds an appealing investment option for those with a risk-averse investment strategy.

4.     Liquidity. Covered bonds are generally considered more liquid than other debt securities. This increased market liquidity makes them easier to buy and sell in the secondary market, enhancing the attractiveness of covered bonds for investors seeking flexibility in their investment portfolios.

5.     Regulatory Framework. Covered bonds operate within a well-defined legal and regulatory framework. These regulations include diversification and quality criteria, ensuring that the assets in the cover pool maintain high quality. The stringent regulatory oversight contributes to effective risk management associated with the bonds, instilling confidence in investors regarding the stability and reliability of their investments.

What makes a Covered Bond secure

What makes a covered bond secure lies in its distinctive features, setting it apart from asset-backed securities and ensuring a robust level of investor protection.

A fundamental distinction is that the loans supporting covered bonds, whether they be residential mortgages or public sector loans, remain on the balance sheet of the issuing bank. In simple terms, this means that even if the institution selling the covered bond faces bankruptcy, investors in the covered bond maintain their access to the cover pool.

For instance, consider purchasing a covered bond from a Wall Street Investment Bank. In the unfortunate event of the bank going bankrupt, investors still retain their entitlement to interest-rate payments and the principal when the bond matures. This dual recourse structure, as defined by the legislative covered bond framework, provides an additional layer of security for covered bondholders.

Essentially, a covered bond operates as a standard corporate bond, issued by a financial institution, with an augmented level of protection for investors. This additional protection typically results in covered bonds receiving AAA ratings, attesting to their high credit quality. The presence of the cover pool, the adherence to regulatory standards, and the dual recourse mechanism contribute to the overall security of covered bonds, making them a reliable and secure investment option in the financial markets.

Where to buy Covered Bonds?

The most accessible marketplace to purchase secure covered bonds is in Europe, notably on the Frankfurter Wertpapierbörse (FWB), also known as the Frankfurt Stock Exchange. In this European market, covered bonds are referred to as Pfandbriefe, and their historical roots in Germany date back to the 1700s.

While the European market remains a prominent hub for covered bond transactions, obtaining these debt investments closer to home, especially in the United States, has historically posed challenges. However, there have been notable developments. In 2006, two U.S. banks, Bank of America and Washington Mutual, ventured into the covered bond market. Unfortunately, their efforts faced a setback due to the credit crisis that unfolded shortly thereafter, hindering the market’s growth.

Despite initial resistance from traders and investors post-2007, there has been a shift in perception. U.S. Treasury Secretary Henry Paulson expressed support for covered bonds in early 2008. On July 15, 2008, the Federal Deposit Insurance Corporation (FDIC) issued guidelines outlining the payment mechanism for covered bonds in the event of a bank failure. This regulatory support aimed to enhance the credibility of covered bonds in the U.S. financial market.

However, enthusiasm for covered bonds in the U.S. appears to have experienced fluctuations. After a peak in interest, there was a significant decline in the issuance of covered bonds from 2016 to 2017. Despite years of meager investment interest, the market dynamics and regulatory frameworks continue to evolve, potentially creating new opportunities for investors interested in these secure debt instruments. As the landscape transforms, it’s essential for investors to stay informed about developments in the covered bond market to identify optimal avenues for purchase.

Who can buy covered bonds?

The accessibility of covered bonds is constrained by their complexity and minimum investment requirements, making them primarily available to institutional and high-net-worth investors. Comparable to other secured products like mortgage-backed securities, covered bonds demand a certain level of financial sophistication and capital commitment.

These financial instruments are not tailored for retail investors due to their intricate nature, emphasizing the need for a comprehensive understanding of their underlying structures. Institutional investors, equipped with the expertise to navigate complex financial instruments, find covered bonds to be a viable component in their investment portfolios.

It’s crucial for potential investors to recognize that, like any financial product, covered bonds carry inherent risks. While they present an interesting investment opportunity, thorough scrutiny is essential. Historical market observations underscore the importance of cautious evaluation, as even sophisticated investments crafted by Wall Street experts may not always guarantee safety.

Covered Bonds vs. Asset-Backed Securities

Recourse Structure

·        Covered Bonds. These instruments operate on a dual recourse basis. Investors not only have unlimited recourse to the issuing bank but also recourse to the pool of assets (cover pool) in the event of the issuing bank’s insolvency. The liabilities for covered bonds remain on the balance sheet of the issuing bank.

·        Asset-Backed Securities. In securitizations, recourse to the issuing Special Purpose Vehicle (SPV) is limited to the realizable assets of the SPV. Investors primarily have recourse to the collateral for the securitization, and the liabilities often do not reflect on the sponsor’s balance sheet.

Issuer and Credit Risk

·        Covered Bonds. Covered bonds issued by regulated financial institutions, often the originators of the assets securing the debt. Credit risk on the assets backing covered bonds remains on the originator’s balance sheet, even if the assets are transferred to an affiliated entity.

·        Asset-Backed Securities. Involve a "true sale" of assets to a bankruptcy-remote SPV, transferring the risk associated with holding those assets. The transferor may still retain some risk in the transferred assets, depending on the structure.

Investor Protection

·        Covered Bonds. Covered bond holders commonly have statutory protection, including priority over underlying assets and a minimum level of overcollateralization.

·        Asset-Backed Securities. Protection depends on contractual terms, and security interests may vary.

Legislation and Pool Characteristics

·        Covered Bonds. Legislation often prescribes characteristics of assets in the cover pool.

·        Asset-Backed Securities. Characteristics depend on the contractual terms of the instrument.

Pool Dynamics

·        Covered Bonds. Involve a dynamic pool requiring periodic refreshing with new, high-quality assets when existing pool assets no longer meet criteria. This refreshing is generally not possible in most securitizations.

·        Asset-Backed Securities. In many securitizations, refreshing assets is generally not possible, and the pool may not have the same dynamic quality as in covered bonds.

Example

An illustrative example of a covered bond is the case of DBS Bank Ltd.’s outstanding mortgage-covered bonds, confirmed by Fitch Ratings in July 2016. These bonds, valued at over $1.5 billion, received a prestigious AAA rating. The guarantee for the covered bond payments was provided by Bayfront Covered Bonds Pte. Ltd.

The high rating was attributed to several key factors contributing to the robustness of the covered bonds. DBS Bank Ltd., as the issuer, held a long-term issuer default rating of AA-. Additionally, a stable discontinuity cap of three notches further solidified the creditworthiness of the covered bonds. Notably, the asset percentage used in the asset coverage test stood at an impressive 85.5%, emphasizing the strength of the collateral backing the bonds.