Types of bonds coverage

What is bond coverage

Bond coverage refers to the financial protection provided by bonds, such as a surety bond, fidelity bond, and performance bond. These bonds guarantee the fulfillment of obligations between three parties: the principal (the party the party required to obtain the bond), the surety (the bonding company or financial institution providing the bond), and the obligee (the party the party benefiting from the bond). Bond coverage helps protect the obligee in case the principal fails to fulfill their obligations, whether it's related to a contract, financial responsibility, or other legal requirements. This coverage ensures that the obligee receives compensation for financial losses incurred due to the principal's failure to fulfill their duties.

Bond coverage explained

Bond coverage encompasses a range of pledges, including securities issued or guaranteed by various entities such as states, central banks, and public companies. It extends to pools of mortgage loans secured by real estate or other assets like vehicles and consumer loans. Maritime liens on ships and equipment, particularly in the transportation sector, also fall under its purview. Additionally, bond coverage may involve mortgages on real estate, though this is less common in sectors like gas and electricity supply in the United States. Through surety bonds, performance bonds, and other types of bonds, bond coverage ensures that obligations are met, offering financial protection against risks such as default, fraudulent acts, or other liabilities. It serves to manage risk for the insured party, typically the first party in a contract, and is often required by laws, regulations, or particular types of contracts. Bond coverage plays a critical role in safeguarding against various forms of financial loss and is an essential component of many businesses' risk management strategies.

Types of bond coverage

Securities. This category provides a solid foundation for bond coverage, offering stability and reliability.

1. Mortgage Loans. Mortgage-backed securities consist of pools of mortgage loans secured by residential or commercial real estate. Additionally, other loan pools, such as car loans, consumer loans, and credit card debts, contribute to the diversity of bond coverage, catering to various financial needs and preferences.

2. Maritime Liens on Ships. This specialized form of bond coverage encompasses the vessel itself and its auxiliary structures and equipment, ensuring the financial security of maritime assets, vital for the shipping and transportation industries.

3. Equipment Bonds. Commonly utilized by transportation companies, particularly in aviation and rail sectors, these bonds cover the costs of equipment. The loan amount often exceeds the equipment's depreciation value. Over time, as the residual value of the equipment surpasses the loan amount, the reliability of these bonds increases, providing long-term financial stability.

4. Real Estate Mortgages. This category involves registered securities backed by real estate assets. While less prevalent, this type of bond coverage is primarily observed in industries like gas and electricity supply in the United States, offering financial security against real estate assets.

Structure

1. Issuer. Typically a financial institution or other corporate entity issuing the bond.

2. Cover Pool. This refers to a pool of assets that secures or "covers" the bond in the event of issuer insolvency. The assets in the cover pool provide additional credit support for the bond but do not affect the contractual cash flow to the investor.

3. Investor. The party purchasing the covered bond.

4. Recourse. Investors have recourse to both the cover pool and the issuer in the event of default. This means that investors can seek repayment from the assets in the cover pool as well as from the issuer.

5. Asset Quality Maintenance. The success of the covered bond depends on the issuer's ability to maintain the credit quality of the cover pool. This involves replacing non-performing loans or prematurely paid debt with performing assets to ensure the ongoing creditworthiness of the pool.

6. Securitized Assets. Unlike securitized assets, where the underlying assets are removed from the issuer's financials, the assets in the cover pool for covered bonds remain on the issuer's financial statements. This means that the issuer retains responsibility for managing and maintaining the cover pool.

Example

In July 2016, Fitch ratings confirmed DBS Bank Ltd.’s outstanding mortgage-covered bonds, worth over $1.5 billion, were rated AAA. Bayfront Covered Bonds Pte. Ltd guaranteed the covered bond payments.

The high rating was partly due to DBS Bank’s long-term issuer default rating of AA-, a stable discontinuity cap of three notches, and the asset percentage used in the asset coverage test of 85.5%.

In this example:

• Issuer: DBS Bank Ltd.

• Covered Bond: Mortgage-covered bonds.

• Guarantor: Bayfront Covered Bonds Pte. Ltd.

• Rating: AAA, indicating high credit quality.

• Asset Coverage Test: The asset percentage used in the asset coverage test was 85.5%, ensuring a strong level of coverage for the bond.

This example demonstrates how covered bonds provide investors with additional security by being backed by a pool of assets, in this case, mortgages. The high rating and asset coverage test further enhance investor confidence in the bond's safety and reliability.