Covered Bonds

Covered bonds, a hybrid between asset-backed securities/mortgage backed securities and normal secured corporate bonds, are an instrument of refinancing, primarily used by mortgage lenders. Unlike secured corporate bonds which provide recourse against the issuer, covered bonds provide a bankruptcy-protected recourse against the assets of the issuer (Collateral Pool) too. Unlike mortgage backed securities which merely provide recourse against the Collateral Pool, covered bonds provide an additional recourse against the issuer too.

Covered bonds have existed in Europe for over 200 years. Until recent years, covered bonds have essentially been a Continental European instrument, known by variety of names such as pfandbriefe in Germany, realkreditobligationer in Denmark, obligations fonciers in France, pantbrev in Spain, etc. However, the sub-prime crisis and the associated aversion for mortgage backed securities gave a new wave of popularity to covered bonds, spreading it to many new destinations such as USA, Australia, New Zealand, Canada, Korea, and Malaysia and so on.

The basic structure of covered bonds evolved over time has two variants – legislative covered bonds, and structured covered bonds. Legislative covered bonds are those that are backed by a specific legislation that provides the bankruptcy protection – this includes most Continental European countries. The other structure is structured covered bonds, where familiar securitization devices involving a true sale to a special purpose vehicle are used, to use the features of common law to provide the bankruptcy protection. UK has had several transactions using the structured covered bonds route.

Unlike securitization, funding by way of covered bonds stays on the balance sheet of the issuer.

Unlike securitization, where ratings are based on credit enhancements alone and often reach AAA levels, the ratings for covered bonds are based on notching-up the rating of the issuer – that is, several notches above the issuer’s own rating, based on the resilience of the structure, inherent asset liability mismatch risk and liquidity risk, and other features.

Notably, covered bonds do not transfer prepayment risk to investors. Covered bonds repay cash to investors on pre-fixed dates, not entirely dependent on the cashflow structure of the Collateral Pool.

Popularity of covered bonds:

The spurt in popularity of covered bonds is evident from the fact that in 2010 and 2011, several significant economies of the world are creating/amending their laws to create legislative platform for covered bonds. This includes USA, New Zealand and Australia. UK FSA also recently moved a proposal to modify the framework for covered bonds.

The outstanding covered bonds volume was estimated at about Euro 2.4 trillion by the European Covered Bonds Council. The issuance in 2010 was significantly higher than that in 2009 by nearly 40%.

Some of the key benefits of covered bonds, compared to mortgage backed securities, are: 

• It is an additional, alternative form of funding. It is important to create secondary mortgage markets that link mortgage creation with capital markets, so as to smoothen cost effective supply of capital to housing and infrastructure. Covered bonds, by providing dual recourse and structured finance features, provide higher ratings than the rating of the issuer, and thus ensure cheaper funding.
• Covered bonds are more investor friendly, as they do not have the prepayment risk and indefinite repayment terms as in case of mortgage backed securities.
• One of the primary reasons why mortgage backed securities came under critique after the subprime crisis is the lack of the so-called skin-in-the-game, that is, originator risk in the transaction. Covered bonds, being full recourse obligations, ensure originator risk.
• The cashflow models for covered bonds are relatively easier to understand. Hence, covered bonds have lesser structural complexity.
• Mortgage backed securities have lost their sheen due to new accounting norms which make off-balance sheet accounting practically difficult for most transactions. In this regime, covered bonds make eminent sense.

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