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Covered bonds

Category — Bond Types
Covered bond is a debt instrument backed by a portfolio of loans, most often mortgages, for which real estate acts as collateral, but other assets, such as pension receipts, can also be covered. Accordingly, both financial institutions and state or regional authorities can act as issuers. The loans that are included in the portfolio remain on the balance sheet of the issuing bank and provide additional protection for holders of covered bonds, which is one of the main differences from secured bonds. In case of secured bonds, assets are most often transferred to an SPV, to which credit risk is transferred accordingly. In addition, covered bond programs are subject to approval by the national regulator, which is often given an additional guarantee. The interest payments on the bonds are covered by the cash flow from the loans. The issuer can replace overdue or early repaid loans in order to minimize risks.

Holders of covered bonds have preferential claims in the event of a default. This right is common to all such bonds, although the procedure for this requirement, along with other features of these bonds (for example compliance of the selected assets with the established criteria, regulation of the bankruptcy procedure) depend on the specific conditions under which the bonds are issued. Thus, even in the event of a default by the issuer, bondholders can still receive interest payments in accordance with the established payment schedule, as well as the principal amount at the maturity date of the covered bonds.

Covered bonds are highly used as a funding instrument alongside deposits, senior bond issues and mortgage securitization. The issue of covered bonds allows issuers to obtain a cheaper funding cost in order to issue mortgage loans for residential and commercial real estate, and also, in some countries as the way to cover government debt. Thus, covered bonds play an important role in the financial system.

Covered bonds are characterized by the following main features, which are determined by a specialized piece of legislation or within the framework of general legislation:

• Bonds are issued by issuers whose activities are under the supervision and control of the relevant government or independent authorities.
• Holders of covered bonds have priority in demanding funds over holders of unsecured bonds.
• The issuer of bonds is obliged to maintain the required amount of assets in the portfolio, as a cover, for the possible coverage of the entire volume of issued bonds.
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